Deflation, Bonds & Bill Gross

Shooting between inflation & deflation with a $500bn jolt...

IF YOU'RE LIKE the typical citizen, you like deflation, writes Dan Amoss for The Daily Reckoning.

   You want your wages and investment income to stretch as far as possible. Falling prices, or rising purchasing power, are a sign of economic progress – the progress resulting from productivity gains and competition.

If you are a modern central banker, on the other hand – anxious to implement your ivory-tower theories – then deflation is enemy No.1.

   (For the sake of clarity, by "inflation," I mean rising prices, and by "deflation," I mean falling prices).

   Central bankers must be the only people who celebrate a 3 or 4% annual reduction in purchasing power. Why? Because "moderate" inflation tends to be good for bankers.

   Too much inflation means debtors will repay loans in increasingly worthless money. With too much deflation, however, falling prices risk taking less efficient businesses down alongside. Debtors will be more likely to default.

   Between inflation and deflation, in short, the Federal Reserve wants to stay in that sweet spot. And if you were Bill Gross, you also would not like too much deflation.

   As chief investment officer at Pimco, Gross manages $130 billion in fixed income investments. Gross thinks like a banker. After all, he's essentially loaning his clients' money to governments, corporations, and households (via mortgage securities). Spiraling deflation could push his bonds into default.

   Gross's great long-term track record owes a lot to the "great moderation" in inflation since the early 1980s. You can generate very high returns by buying high-yielding, long-maturity bonds when inflation is high and holding them while inflation cools off. This was the best strategy for bond investors from the early 1980s until today.

  
Rather than deflation, Gross should actually worry about a decade-long resurgence in inflation. A rising cost of living destroys the real purchasing power of fixed-income loans. But surprisingly, he fears that deflating house prices will drag the US economy into a Japanese-style slump. Default is what scares him most.

  
His solution? Gross wants the government to print money and Treasury bills to prevent deflation happening here.

  
In his July 2008 investment outlook, available on Pimco's web site, Gross writes an open letter to Democratic presidential nominee Barack Obama. Presuming Obama will be the next president, Gross urges him to dramatically expand the federal budget deficit until it reaches a trillion dollars.

  
To quote: "While the Republicans will blame you for years and label you 'Trillion-Dollar Obama' in future campaigns, there is, in fact, not much that you or any other president can do. You've inherited an asset-based economy whose well has been pumped nearly dry with lower and lower interest rates and lender-of-last-resort liquidity provisions that have managed to support Ponzi-style prosperity in recent years."

  
The US economy "will need an additional jolt of $500 billion or so of government spending real quick," pleads Gross. His comically simple formula for GDP – this $500 billion "jolt" to the slowing real economy – is as follows:

  
"Some quick math for you, sir: Gross private domestic investment (machines, houses, inventories) has declined by $200 billion since its peak in late 2006. Due to higher unemployment and energy costs, domestic consumption will soon be $300 billion less than it should be if we are to return to historical economic growth rates. According to that old Consumption + Investment] + Government spending formula (scratch the trade deficit for now), then when C + I is reduced by $500 billion, G should increase by that amount in order to fill the gap.

  
"The G, sir, is you – the government deficit, the fiscal stabilizer popularized by Keynes following the Depression. And since the fiscal deficit for 2008 is likely to press $500 billion even before you take the oath of office, well, there you have it: $500 billion + $500 billion = $1 trillion big ones, probably by sometime in 2011 or so."

  
Only a true Keynesian could argue that such an extraordinary waste of capital is a good thing. And only a Keynesian would believe that the simple GDP equation could summarize a vastly complex, adaptive economy.

  
I've always been skeptical of GDP as a measure of economic progress. It treats dollars spent and dollars invested equally (a dollar invested adds to capital formation, while a dollar spent subtracts from it). The GDP equation also treats government spending as a good thing. It is not. Aside from spending on the occasional "public good," it just sucks capital out of the efficient, adaptive private sector and doles it out to politically powerful voting blocks.

  
Gross' prescription to "save" the economy through wasteful spending would do much more harm than good. He aptly notes that the US depends on foreigners to continually reinvest US Dollars back into the US economy and government.

  
As OPEC – the oil cartel – well knows, many of the dollars recycled back into the Unites States were originally exchanged for oil imports. Bill Gross acknowledges that the US economy has an "energy cost" problem. But what does he think oil exporters' reaction to an extra $500 billion spending "jolt" will be?

  
It won't be pretty. Major oil exporters will demand higher oil prices and higher interest rates to offset what they know will be an ever-growing supply of US Dollar assets.

  
Would you invest in an asset if you knew the future supply of that asset were guaranteed to increase at a rapid rate?

  
I have a more constructive suggestion for the next president: DON'T dream up creative new ways to suck $500 billion in capital out of the private economy and redirect it into vote-buying programs. DO take a crash course on how the energy supply chain works, and invite Congress.

  
Energy ignorance is the biggest immediate obstacle to the government being part of any sort of solution. But with Keynesian economics ruling in Washington – just as at Pimco – Inflation is here to stay, albeit with occasional "deflation" scares.

  
Adjust your portfolio accordingly.