Monday, October 06, 2008

Bill Gross comments on our economic situation

From his monthly Investment Outlook (original emphasis):

PIMCO’s Investment Committee to a man (no women yet) believes that capitalism is the best and most effective economic system ever devised, but it has a flaw: it is inherently unstable. Every economy, capitalist, socialist, or communist requires long-term capital assets to allow it to function: buildings, roads, factories, homes, all of which have expected lives of 30 years or more. A classic communist system would build these things and it would be done – no financing, no debt coming due, and no worries. Capitalism, however introduces an instability because it uses short-term profit maximization via the buying and selling of debt and equity that finance these same capital projects. Because capitalism has a dynamic of profit maximization at its core, companies and households take on more debt or less, issue more stock or less, and then trade these obligations amongst each other, creating the possibility of bubbles and bankruptcy, faux prosperity and instability.

It is during these periods of potential bankruptcy and accelerating instability, however, that capitalism becomes particularly vulnerable. Confidence is replaced by fear. Any economy requires a continual replenishment of buildings, roads, and yes homes in order to survive. But whereas an old-style communist government would simply budget them into their new 5-year plan and direct their people to build them, capitalism must accomplish the same task via prices, markets, and confidence that this invisible hand will lead to future profits. Take your home for instance. While housing prices for long periods of time in the 20th century didn’t go up or down much, it’s fair to say that you would be reluctant to buy a house (and your bank reluctant to lend you a mortgage) if you thought it was going to go down in price. Same thing when companies build factories and invest in research and development; profits and in turn higher prices are fundamental drivers of the capitalistic ethic.

A month ago when I spoke to a potential financial tsunami, it was not to bail out our position of already well protected Agency mortgage-backed bonds. It was to alert you and yes, policymakers, that this inherent instability in our capitalistic system was threatening to feed on itself first in the housing market and then spreading to financial institutions – banks, investment banks and insurance companies as the sale of assets in the process of delevering led to home foreclosures and then bankruptcies for weak institutions that held assets of all kinds. That was not, I think, an inaccurate assessment as recent events have proven. But importantly, because prices are going down in every asset class, the threat to future investment in long-term capital projects and the real economy becomes magnified. That doesn’t mean of course that capitalist investors must be guaranteed a profit. Far from it. But when prices in all asset categories decline by double-digits, well then Washington, London, Frankfurt, Tokyo, and Beijing – we have a problem. I reproduce last month’s asset price chart to accentuate my point.

Now, as recognition of a systemic period of capitalistic instability becomes apparent, the focus has legitimately shifted to a systemic solution. Much of the focus has been on U.S. policy and rightly so. It is here where the excesses of exuberance were most pronounced. But, up until the Treasury’s $850 billion rescue package, the policy responses may have been necessary and significant, but they were ad hoc and perhaps insufficient. A systemic delevering likely requires a systemic solution, which moves beyond cyclical interest rate cuts, liquidity provisions, or even the purchase of subprime mortgage-backed bonds. We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.

Gross predicts a lengthy recession but no depression.

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