Back in April 2012, in "How The Fed's Visible Hand Is Forcing Corporate Cash Mismanagement" we first explained how despite its best intentions (to boost the Russell 2000 to new all time highs, a goal it achieved), the Fed's now constant intervention in capital markets has achieved one thing when it comes to the real economy: an unprecedented capital mismanagemenet, where as a result of ZIRP, corporate executives will always opt for short-term, low IRR, myopic cash allocation decisions such as dividend, buyback and, sometimes, M&A, seeking to satisfy shareholders and ignoring real long-term growth opportunities such as R&D spending, efficiency improvements, capital reinvestment, retention and hiring of employees, and generally all those things that determine success for anyone whose investment horizon is longer than the nearest lockup gate. Today, one calendar year later, none other than Bill Gross, in his first investment letter of 2013, admits we were correct: "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."
It is this that should be the focus of economists, and not what the level of the S&P is, as it is no longer indicative of any underlying market fundamentals, but merely how large, in nominal terms, the global balance sheet is. And as long as the impact of peak central-planning on "business models" is ignored, there can be no hope of economic stabilization, let alone improvement. All this and much more, especially his admissions that yes, it is flow, and not stock, that dominates the Fed market impact (think great white shark - must always be moving), if not calculus, in Bill Gross' latest letter.
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.
William H. Gross