A Comment on "A Prolegomenon to Any Useful Analysis of Modern Finance"
Yet More Halloween Blogging: "I Find Your Lack of Faith… Disturbing…" Edition

Department of "Huh?!": What Is Bill Gross Saying? Edition

I know what Robert Barro's or Narayana Kocherlakota's or Robert Lucas's model of the world is--and it is pretty clear to me that their models are wrong, for they have been greatly surprised by reality over the past four years in lots of ways that people in the Bagehot-Minsky-Kindleberger or Keynes-Hicks-Tobin traditions have not been surprised.

And I know that William H. Gross of PIMCO is very smart, and very good at this. But I cannot figure out what his model of how the world works is:

William H. Gross: PIMCO | Investment Outlook - Pennies from Heaven: [T]he investment question du jour should be “can you solve a debt crisis with more debt?”… Policymakers have been striving to answer it in the affirmative ever since Lehman 2008 with an assorted array of bazookas and popguns: 0% interest rates, sequential QEs with a twist, and of course now the EU grand plan… write-offs for Greece, bank recapitalizations for Euroland depositories and the leveraging of their rather unique “EFSF” which requires 17 separate votes each and every time an amendment is required. What a way to run a railroad…. Not being one to cast pearls before swine or little Euroland PIGS for that matter, I would tentatively agree with one huge qualifier:

As long as these policies generate growth….

The lack of growth, as explained in prior Outlooks over the past few years, is structural as opposed to cyclical, and therefore relatively immune to interest rate or consumption stimulative fiscal policies. 1) Globalization, 2) technological innovation, and 3) an aging global demographic have all combined to dampen policy adjustment post Lehman and will inexorably continue to work their black magic going forward. To defeat this misunderstood structural voodoo, countries would have to mint pennies by the billions, pretend to lose them, and then incredibly find them strewn all across their city streets like some global Easter egg hunt. Not gonna happen.

The situation, of course, is compounded now by high debt levels and government spending that always used to restart capitalism’s private engine…. [S]overeign debt at 80-90% of GDP acts as a barrier to growth… debt service and interest rate spreads start to rise at these debt levels, a greater and greater percentage of a nation’s output must necessarily be diverted to creditors who in turn become leery of reinvesting in a slowing economy….

Halting the downward maelstrom is what current monetary policy is attempting to accomplish. With fiscal policy in most developed countries incredibly restrictive instead of stimulative, central banks have assumed the helm on their own – but it has been a long and relatively futile watch. Structural growth problems in developed economies cannot be solved by a magic penny or a magic trillion dollar bill….

My original question – “Can you solve a debt crisis by creating more debt?” – must continue to be answered in the negative, because that debt – low yielding as it is – is not creating growth…. The Rogoff/Reinhart biblical parallel of seven years of fat followed by seven years of lean is not likely to be disproven in this cycle. The only missing input to the equation would seem to be how many years of fat did we actually experience? More than seven, I would suggest…

If nominal GDP growth had just jumped from 4%/year to 7%/year and if the consequence had been the real growth had gone from 2.5 to 3.0%/year while core inflation had gone from 1.5% to 4.0%/year and nominal ten-year Treasury rates had gone from 2.5 to 6.0%/year, I would say that the market had spoken: thet too much (risky) debt could not be cured by issuing lots more (safe) debt. But if that is happening at all, it is happening in some alternative universe: not here, not now.

Here and now the principal immediate disease of the economy continues to be (in Wicksellian terms) that the natural rate of interest is lower than the market rate and is in fact less than zero, (in monetarist terms) that nominal GDP is too low and is expected to grow too slowly given the current level of wages and prices, (in Bagehot-Minsky-Kindleberger-Reinhart-Rogoff-Koo terms) that the risk tolerance of the market is too low given the still-extraordinary level of leverge, (in Bernanke-Gertler-Hubbard terms) that a wave of moral hazard and adverse selection has overwhelmed and broken the credit channel. All of these diagnoses are not quite identical, but the overlap between them is enormous. And they all admit of the same cure: Jubilee. A reduction in risky debt and its replacement in portfolios by an increase in safe debt. This can be accomplished through either guarantees of risky debt by the credit-worthy, by explicit write-downs and refis, or by the I-word.

Oh, there are other more chronic diseases of the American and the world economy: globalization one wrong, overfinancialization, overhealthcareadministrationization, rising inequality, financialunderregulationization, et cetera--and some of these played a role in setting up the current crisis. But you don't have to fix a tire through the puncture. And we shouldn't believe that we must.

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