Gross is no chicken little. He runs the biggest bond fund in the world. When he says that inflation and currency debasement are in our future, you should listen.
Money for Nothin’
Writing Checks for Free
It was Milton Friedman, not Ben Bernanke, who first made reference to dropping money from helicopters in order to prevent deflation. Bernanke’s now famous “helicopter speech” in 2002, however, was no less enthusiastically supportive of the concept. In it, he boldly previewed the almost unimaginable policy solutions that would follow the black swan financial meltdown in 2008: policy rates at zero for an extended period of time; expanding the menu of assets that the Fed buys beyond Treasuries; and of course quantitative easing purchases of an almost unlimited amount should they be needed. These weren’t Bernanke innovations – nor was the term QE. Many of them had been applied by policy authorities in the late 1930s and ‘40s as well as Japan in recent years. Yet the then Fed Governor’s rather blatant support of monetary policy to come should have been a signal to investors that he would be willing to pilot a helicopter should the takeoff be necessary. “Like gold,” he said, “U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”
Investors and ordinary citizens might wonder then, why the fuss over the fiscal cliff and the increasing amount of debt/GDP that current deficits portend? Why the austerity push in the U.K., and why the possibly exaggerated concern by U.S. Republicans over spending and entitlements? If a country can issue debt, have its central bank buy it, and then return the interest, what’s to worry? Alfred E. Neuman for President (or House Speaker!).
Well ultimately government financing schemes such as today’s QE’s or England’s early 1700s South Sea Bubble end badly. At the time Sir Isaac Newton was asked about the apparent success of the government’s plan and he responded by saying that “I can calculate the movement of the stars but not the madness of men.” The madness he referred to was the rather blatant acceptance by government and its citizen investors, that they had discovered the key to perpetual prosperity: “essentially costless” debt financing. The plan’s originator, Scotsman John Law, could not have conceived of helicopters like Ben Bernanke did 300 years later, but the concept was the same: writing checks for free.
Yet the common sense of John Law – and likewise that of Ben Bernanke – must have known that only air comes for free and is “essentially costless.” The future price tag of printing six trillion dollars’ worth of checks comes in the form of inflation and devaluation of currencies either relative to each other, or to commodities in less limitless supply such as oil or gold. To date, central banks have been willing to accept that cost – nay – have even encouraged it. The Fed is now comfortable with 2.5% inflation for at least 1–2 years and the Bank of Japan seems willing to up their targeted objective to something above as opposed to below ground zero. But in the process, zero-bound yields and their QE check writing may have distorted market prices, and in the process the flow as well as the existing stock of credit. Capital vs. labor; bonds/stocks vs. cash; lenders vs. borrowers; surplus vs. deficit nations; rich vs. the poor: these are the secular anomalies and mismatches perpetuated by unlimited check writing that now threaten future stability.
Ben Bernanke has publically acknowledged these growing disparities. “We are quite aware,” he said in November 2011, “that very low interest rates, particularly for a protracted period, do have costs for a lot of people… I think the response is, though, that there is a greater good here, which is the health and recovery of the U.S. economy… I mean, ultimately, if you want to earn money on your investments, you have to invest in an economy which is growing.”
That growth now is to be measured each and every employment Friday via an unemployment rate thermostat set at 6.5%. We at PIMCO would not argue with that objective. Yet we would caution, as Bernanke himself has cautioned, that there are negative consequences and that when central banks enter the cave of quantitative easing and “essentially costless” electronic printing of money, there may be dragons.
Investment conclusions
Investors should be alert to the longterm inflationary thrust of such check writing. While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the “out” years towards which long-term bond yields are measured. You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies. In addition, be aware of PIMCO’s continued concerns about the increasing ineffectiveness of quantitative easing with regards to the real economy. Zero-bound interest rates, QE maneuvering, and “essentially costless” check writing destroy financial business models and stunt investment decisions which offer increasingly lower ROIs and ROEs. Purchases of “paper” shares as opposed to investments in tangible productive investment assets become the likely preferred corporate choice. Those purchases may be initially supportive of stock prices but ultimately constraining of true wealth creation and real economic growth. At some future point, risk assets – stocks, corporate and high yield bonds – must recognize the difference. Bernanke’s dreams of economic revival, which would then lead to the day that investors can earn higher returns, may be an unattainable theoretical hope, in contrast to a future reality. Japan we are not, nor is Euroland or the U.K. – just yet. But “costless” check writing does indeed have a cost and checks cannot perpetually be written for free.
William H. Gross
Managing Director
Muck About says:
Bill Gross has been fighting the Fed for years. His customers have lost.
But he’ll be right — sooner or later.. That’s the joy of a “one-note” Charlie that takes a position and repeats it over and over until, sooner or later, it’s the correct one and he can claim he’s been saying that all along.
I wouldn’t invest a dime with him but then I’m short long bonds at the moment and don’t want to be a hypocrite. My advise? Don’t buy bonds. Anyone’s bonds. Time will tell… (And then I can say, “I was saying that all along!”)
MA
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3rd January 2013 at 2:04 pm
sangell says:
Gross did alright by me this year. His Total Return Fund earned over 10%! The problem as Gross recognizes and Bernanke and Obama apparently do not, is that interest rates are a price signal markets need to function properly. They are the reason a person with good credit can borrow money at lower rates than a person with bad credit. There is less risk the person with good credit will not pay the money back. The same reasoning applies to business investment. A company with a new product, drug or process that promises to make lots of money attracts lots of a capital. Companies that are losing money or whose products are becoming obsolete can’t raise any capital.
What Bernanke has done is leveled the playing field by rigging interest rates. Zombie companies like J.C Pennys or GM can stagger on taking market share from better run companies like Kohls or Ford. Money is made available for solar energy companies and wind farms that haven’t a prayer of making a profit with natural gas prices at $3 or $4 dollars per million BTU’s get funded by the government because the government doesn’t have to borrow money at market rates and requires utilities buy the output from these white elephants no matter how expensive it is.
This malinvestment is permeating the economy as a result of these interest rate distortions. The real danger now is that if this Central Bank interest rate rigging falls apart and all those malinvestments will blow up and asset prices will collapse. Just consider what would happen to the housing market if mortgage rates returned to just 5 or 6%. Millions of more homes would be underwater, defaults and foreclosures would explode, the GSE’s would need hundreds of additional billions of fresh government funds. In effect Bernanke has put his finger in a hole in Hoover dam and he dare not take it out less the economy be swept away.
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3rd January 2013 at 2:53 pm
IndenturedServant says:
” His Total Return Fund earned over 10%!”
I don’t have the actual numbers but wasn’t inflation on things we need like oil, gas, food, clothing etc, above 10%?
I_S
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3rd January 2013 at 3:38 pm
sangell says:
I’m not going to make my own estimate of what real inflation is. Its not the same for everyone anyway.
It depends on what and how you spend your money. Since I retired I am more price sensitive to things like medical insurance and food prices than I am to other costs like gasoline or clothes. I mean if you spend most of the day in your underwear in front of your computer what do I care what a new suit costs? I don’t intend to ever buy a new one again.
Back to Gross, he admits he blew it in 2011 but he’s a smart guy who understands what is going on so, while I’m happy with him earning 10% this year my main reason for letting him manage a bit of my money is that I trust him not to lose capital.
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3rd January 2013 at 4:25 pm
ecliptix543 says:
I refuse to trust any of them, even if they’re right from time to time.
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3rd January 2013 at 8:20 pm