Tuesday, 24 February 2009

Pimco's Bill Gross Answers His Own Questions. Anyways, Good Answers, Specially Those About U.S. Bank Nationalisations

We failed to get a picture of him, but it seems he got rid of the moustache. He is Bill Gross, the manager of the world's largest bond fund, Pacific Investment Management Co., or Pimco. The man knows this subject well. Read carefully the part about bank nationalisations.

For the entire ''interview,´´
click here.

Question: Mr. Gross, is this a recession or a depression?
Answer: We don’t know yet, Madame Congresswoman. Recessions are cyclical downturns of a relatively brief time frame, characterized by inventory corrections and addressed by low interest rates and mild doses of fiscal stimulus. Depressions are more extreme with double-digit levels of unemployment but defined more importantly by credit contraction and debt liquidation. The deflation that normally accompanies a depression is dangerous not because prices are going down, but because the “for sale” sign goes up on the credit markets which have always made capitalism possible. At the moment, you policymakers are attempting to prevent that. We shall see.

Question: How did this happen so fast?

Answer: Trillions of dollars of credit have been sucked out of the financial system over the past 12 months. Banks may be lending but the larger shadow banking system is not. All of those SIVs and credit default swaps that once generated credit are now contracting and pulling the real economy down with them. Think of it this way: If you had three or four pints of blood drained from your body you’d be on life support, very quickly. Same thing now. The solution is for government spending to simulate a transfusion of whole blood, plasma, or whatever’s available.

Question: How bad could this get?

Answer: No one knows for sure, but common sense would provide a good guess. If the government cannot substitute credit to the same extent that it is disappearing from the private system, then the U.S. and global economies will retreat. If the economy is viewed as a bathtub filled with water (credit) at two different times with two different levels, then draining it back down to the lower first level might reduce economic activity proportionately. Liquidate debt (credit) to 2003 totals and you just might reduce economic activity (GDP) to 2003 numbers as well. Whoops! That would mean a 10%+ contraction in the economy with unemployment approaching the teens. Keep that bathtub full!

Question: What can be done?

Answer: Keeping the tub sufficiently full means advancing policies in content and magnitude never contemplated since the days of FDR. The U.S. and global financial systems require credit creation and foreclosure prevention, not bank nationalization as currently contemplated by some. Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s. To date, PIMCO’s Mohamed El-Erian’s imperative of “shock and awe” has been more like “don’t bother us, we’re working on it.” Get moving. Risk being bold – Washington.

Question: Are there no negative consequences from “shock and awe?” Will these policies destroy capitalism while trying to save it?

Answer: Good question. The substitution of the benevolent fist of government for the invisible hand of Adam Smith involves risk. The private system is the heart of capitalism and generates most of its productivity, so more government usually involves less prosperity and certainly more inflation. PIMCO recommends a 180-degree turn towards government only as a last resort. They have the only credible checkbook in town. Will those checks create inflation? Let’s hope so provided it is low and stable over time. Policymakers are more than vocal about attempting to reflate the economy, which in essence means a hoped for return to nominal GDP growth levels of 5-6%, the majority of which might actually come in the form of higher prices as opposed to increased production. This Faustian bargain would be acceptable if only to stabilize what now appears to be an even more dangerous deflationary debt liquidation.

Question: Why do we assume that the U.S. can unilaterally do whatever it wants?

Answer: Much like we are the world’s strongest nation militarily, we entered this crisis with certain economic and financial strengths relative to all other nations. Our reserve currency status was the primary one which means that we can write checks in our own currency and they are accepted all over the world – sort of like American Express Travelers Cheques. This privilege, however, can be and is being abused. Travelers Cheques are acceptable only when redeemed at 100 cents on the dollar. Lately, quasi-American dollars in the form of Aaa CDOs, corporate bonds, and even national champion bank stocks have floundered closer to zero than par. There is fear on foreign shores that even U.S. agency debt may not be honored and that U.S. Treasury debt itself, when “repoed” as in prior years, may now suffer from counterparty risk. Global willingness to accept American dollars is being tested. Granted, the U.S. currency has appreciated strongly against its counterparts during most of this crisis, but technical short covering as opposed to a flight to quality may have been the dominant consideration. Watch the dollar. If it falls hard, there may be nothing policymakers can do to restore the ensuing financial chaos.

Question: What do you think about nationalizing the banks?

Answer: I think Roubini, Dodd and Greenspan haven’t thought this one through. The U.S. isn’t Sweden, and not just because our blondes aren’t au naturel. Their successful approach revolved around a handful of banks but we have 7,500, as well as many S&Ls and credit unions, which would have to be flushed into government hands. Regulators are overwhelmed as it is, and if you thought Lehman Brothers was a mistake, just standby and see what nationalizing Citi or BofA would do. Our banks remain at the heart of domestic/global financial transactions and daily clearing, while those Scandinavian banks were not. PIMCO would not dispute the need to further capitalize systemically important banks via convertible bonds held by the government, which unfortunately dilute shareholders’ interests. To go further, however, and “haircut” senior debt or even existing preferred stock similar to that issued via the TARP would create an instability policymakers should not want to risk. In turn, forcing creditors to take haircuts would undermine other financial sectors such as insurance companies and credit unions. The goal of future policy should be to recapitalize lending institutions while maintaining the basic infrastructure of credit markets. Outright nationalization and haircutting of creditors will do just the opposite.

1 comment:

  1. Excellent! I agree with the man. As we discussed yesterday, outright bank nationalizations would be a big mistake. We need to drop our illusions and delusions and restructure. Same goes for the auto industry. If that happens, the future may be bright. If it does not, if we persist in delusional behavior and fear, things won't look good.