Putting the World to Rights Again
John Mauldin's Outside the Box

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This week's letter is from Financial News Online. Located in London, they are one of the leading sources of information about Europe's investment banking, fund management and securities industries. Financial News ran a piece last week that was a series of letters over the summer between two of my all time favourite analysts, Bill Gross of Pimco and Stephen Roach of Morgan Stanley.

Gross and Roach exchanged letters over the summer expressing their outlook on many current economic issues and allow us a glimpse into how they perceive the world today. One of the main concerns in their discussion was the U.S. dollar and they wonder if the "Buck is going to Duck?" I hope you enjoy their bantering as much as I did and it helps you think "Outside the Box."

Putting the World to Rights Again

Bill Gross, chief investment officer at Pimco, and Stephen Roach, chief economist at Morgan Stanley, are two of the deepest thinkers on the state of the global economy. Over the summer they swapped their thoughts on the price of oil, the US current account deficit and the future of China, among other topics, exclusively for Financial News.

From: Roach, Stephen (Equity Research)

Sent: August 13, 2004

To: Gross, William

Subject: Getting the world moving again

Dear Bill,

When we last chatted, we shared our concerns on the outlook for the world economy. At the time, that was more conjecture than reality. But recent events suggest that global growth risks are tipping to the downside. An oil shock, a sputtering of the over-extended American consumer, the China slowdown, and a growth shortfall in Japan all paint a picture of prospective weakness in a still unbalanced global economy. Meanwhile, in one of the great ironies of central bank theatre, the Federal Reserve is plodding ahead in its campaign of monetary tightening. This strikes me as a recipe for disaster - a pro-cyclical policy gambit that could well spark the next global recession.

As you know, I had been a strong advocate of a bold normalisation campaign for the Fed. I had publicly urged the US central bank to boost its policy rate from 1% to 3% in one fell swoop. Yet earlier this year, when I made this seemingly radical recommendation, oil prices were $10 lower and there was much more vigour to the US and global growth cushion. I urged the Fed to take advantage of this growth window in order to get short-term real interest rates back towards more normal levels. Now, courtesy of the oil shock and increasingly brisk global headwinds, that window has been slammed shut. The case for "opportunistic normalisation" is in tatters.

This is starting to sound like a nightmare scenario. By getting themselves into this bubble mess and using aggressive easing tactics to temper any post-bubble carnage, major central banks are lacking in ammunition to deal with adverse shocks. The levers of fiscal stimulus have also been pushed to the max. Currency manipulation is a zero-sum game. Property markets are nearing the end of a long wave of appreciation. And you have argued that the "salad days" in the bond market are over. Maybe oil prices plunge and the world quickly wakes up from nothing more than a bad dream. But maybe geopolitical angst prevents that from happening. If that's the case, how are we going to get the world moving again?

Best regards, Steve

From: Gross, William

Sent: August 18, 2004

To: Roach, Stephen

Subject: Re: Getting the world moving again

Dear Steve,

As a bond market pessimist writing to an economist of the same at least temporary persuasion, I think we should remind each other that forecasting Armageddon is a tricky business. Mankind's indomitably optimistic spirit has a habit of postponing foggy days until the gloomsters' warnings and ultimate sanity are called into question. Crying wolf must be done infrequently and with relatively precise timing to be effective and to merit the "Order of the Savant".

Still, I share many of your concerns, although I come at it from a slightly different intellectual bent. I shall therefore rail against the orthodox view right along with you and offer some conclusions of my own while trying to answer your question as to how to get the world moving again. It seems to a lot of economists/forecasters that we've rarely been in a more balanced economy. GDP in the US is growing at 4%; productivity is high; inflation is low; job growth is resuming. Yet to me, beneath these Loch Ness waters of optimism lies the potential for a monster in the form of excessive global debt to rear its infrequent yet oftentimes destructive head.

Debt and its accumulation are rarely dangerous when lenders are willingly extending their funds or when the cost of those funds is low and/or declining. That has been the case for most of the past two decades, as the US and other G7 counties embarked on a journey of disinflation accompanied by accelerating debt. Corporations, individuals and sovereign nations alike throughout most of the period gorged themselves at the table of cheaper and ultimately nearly free money - aggrandising lifestyles, bringing consumption forward, financing peacetime and wartime projects of questionable benefit. The problem is that ultimately someone must pay. As interest rates move upward from historic lows, debt service costs reduce profitability, even productivity.

It is my contention that much of our current cyclical prosperity has been due to the "productivity" of lower interest rates in a finance-based, debt-laden global economy. As those yields reverse, they must be carefully manoeuvred by central bankers in order to prevent bubble popping and the global instability that your last e-mail refers to.

Unfortunately, central bankers are merely human, and finding the sweet spot of "neutrality" in an unbalanced world burdened with debt is a near impossible task. Too high a rate risks tipping the global economy into recession. Too low a rate extends the potential for bubbles in real estate, oil, and associated commodities and hard assets. Even bonds as they are currently priced are not impervious to the need for a near perfectly neutral short rate.

So what to do: how to get the economy moving again, as JFK once put it. Certainly, lower oil prices would inject a needed shot of adrenaline in the arm of the consumer and business entrepreneur alike, but that is a wish, not a practical solution. I would suggest that the best remedy is one that requires the world to swallow its medicine - not the old-fashioned castor oil, which spoke to liquidating labour or businesses - that is clearly unacceptable.

My solution is a longer-term one that requires a re-emphasis on savings instead of debt accumulation, a gradual erosion of debt burdens via mild 2% to 3% inflation, and a rebalancing of trade deficit imbalances via currency realignments. If we've brought consumption forward, we must reverse the process and begin to save some nuts for a long demographic winter. Such steps, of course, must be engineered as finely as the ones central bankers are attempting via interest rate policy.

You correctly point out that mis-steps could lead to a global recession. If we do fall towards recession, do governments have the ammunition to re-engineer another recovery?

All the best, Bill

From: Roach, Stephen (Equity Research)

Sent: August 25, 2004

To: Gross, William

Subject: Rebalancing the world

Dear Bill,

The risk of this exchange is that we begin to feed on each other's despair and end up in a worse place than either of us truly envisions. I take your point on the forecast of Armageddon. Over the long sweep of economic history, meltdowns have, indeed, been few and far between. Call it human spirit, globalisation, productivity, or technological change - the world has an indomitable positive bias that almost always seeks the higher ground.

The trick today, as we both seem to agree, is in finding that higher ground. My hope is in what I call rebalancing - namely, the transition from an unbalanced global economy that is incapable of sustained recovery to a more balanced world. That means a world without enormous disparities in current account balances - mainly America's massive deficits and Asia's outsize surpluses.

It also means a shift in the mix of global saving - with the US boosting its saving by cutting back on excess consumption and runaway budget deficits, and the rest of the world putting its savings to work in supporting domestic demand.

I know, easier said than done. But here's one way to pull it off: let the dollar fall. Clearly, America's massive balance of payments deficit - a record 5.1% of GDP in early 2004 that is likely to get worse before it gets better - begs for a weaker dollar. Yet the broadest measures of the dollar are down only about 10% over the past two-and-a-half years.

In large part, this limited decline reflects aggressive dollar buying by foreign central banks. They are fearful that their currencies will strengthen as the dollar depreciates, undercutting their export growth. Lacking in consumption growth, any currency-related hit to exports is a serious threat. So Asian central banks buy American bonds, which then support US asset markets. And asset-dependent Americans buy Asian goods in return. What a crazy way to run the world!

If the dollar is allowed to find its natural and presumably lower level, a sense of sanity may be restored that might actually turn me into an optimist. In the US, interest rates will probably rise as foreign investors demand a premium on dollar-based investments. That will curtail US consumption and boost saving.

Conversely, as currencies weaken elsewhere in the world, export-led growth strategies will be called into question - forcing Asians and Europeans alike to draw down surplus savings, push through reforms and boost domestic consumption. Such a rebalanced world will then be in much better shape to support sustained economic growth. The trick is to get policy on the same page.

Bill, I don't know about you but I've lost confidence in the world's fiscal authorities. Only central banks have the wherewithal to pull it off. But by fuelling the debt-driven super-liquidity cycle of the past several years, I fear they, too, have now become part of the problem. Central banks used to be the tough guys and you used to be one of the world's leading bond market vigilantes who held them accountable for doing the right thing. Where are the vigilantes now that we really need them?

Best always, Steve

Bond market uncertainty leads to a rumble in the financial jungle
27 Sep 2004

From: Gross, William

Sent: August 27, 2004

To: Roach, Stephen

Subject: Re: Rebalancing the world

Dear Steve,

So the world's on my shoulders now? I must agree that vigilance is the price of liberty or a sound economy for that matter, but my first obligation is to my clients. Fortunately, the required bond market vigilance usually serves both constituencies but not always - especially today. While I would concur that monetary authorities have been drinking with reckless abandon without turning over the keys to a designated driver, there's only so much I can do. What? Sell my bonds and accept their penal yield of 1.5% in short-term paper? Only if I thought that intermediate and long-term bond prices were in a serious bear market.

As you point out, the Chinese and the Japanese are foolishly standing in the way, purchasing US Treasuries at the rate of $300bn a year to prevent their own currencies from appreciating. Until they come to their senses and stop the buying stampede, I've got to join the party too. Besides, if the world economy is so precariously imbalanced, wouldn't a "tipping" towards recession be just the scenario a bond market vigilante would want to see? Recession = higher Treasury prices you know.

Your solution to rebalance the global economy is mine as well, except I have impatiently been suggesting a dollar decline for some quarters now and have been rewarded to the tune of 10% but not the 20% to 30% required. Our joint entreaty reminds me of the days when Muhammad Ali would brashly forecast the outcome and the timing of his knockout. In dollar terminology, he might now say that "the Buck must Duck - if it lasts the year it'll be Luck!" Balance of trade deficits approaching 6% of GDP, and synonymous of near bankrupt emerging market nations, suggest that the knockdown and TKO must be imminent.

But I'm afraid that neither you nor I have the power of the "greatest of all tiiiime". Forecasting the round will inevitably frustrate us for no other reason than those unpredictable Chinese and their own domestic priorities. They can hang in there longer than we expect, bobbing and weaving, clinching and holding - anything to prevent their products from losing what would still be an overwhelming pricing advantage.

At some point though, and in some future round, either they reduce their purchase of Treasuries or they revalue upward their renminbi. That, to me, will be a big step towards global rebalancing since it means higher US inflation, higher US interest rates, and a slowing of the US consumer which is a big part of the problem to begin with. If the Chinese take these "vigilant" steps then I will join them - selling bonds and sitting out the match in order to fight another day.

Since you have been to Asia so many times in the past few years, I'm sure you have some insight in terms of the timing of this global rebalancing punch. Instead of asking me when I am going to be vigilant, you should be asking the Chinese and the Japanese when they are going to do the same. The world has changed a lot in the past decade and a new pair of financial studs has displaced yours truly and others from their number one power ranking. If the "Buck is going to Duck", can you ask them to tell me what round?

Hopefully, Bill

From: Roach, Stephen (Equity Research)

Sent: September 15, 2004

To: Gross, William

Subject: Muhammad Ali

Dear Bill,

OK, I admit I was being unfair. You are right, of course - bond vigilantes have become an endangered species. The bond junkies in Japan and China now call the shots for the US and for the rest of a US-centric world. And quite frankly, I don't have a clue as to when and under what circumstances Asian demand for US Treasuries could reverse course. Nor do I think that the monetary authorities in Japan and China have a well-scripted endgame that will alter the balance of power in world financial markets.

But time is growing short. That's because America is upping the ante big time on what we are demanding of the rest of the world to finance our increasingly profligate ways. The US current account deficit hit 5.7% of GDP in the second quarter of 2004 - easily a record for America and, in dollar terms, a record financing burden for the world at large. Putting it another way, the US now needs an average of $2.6bn of foreign capital inflows each and every business day to finance the growth of our saving-short economy.

Here's where it gets especially interesting. Private demand for dollar-denominated assets is now on the wane. As a result, official flows (those from foreign central banks and other monetary authorities) have had to fill the void. Over the 10 months ending in June 2004, official buying accounted for 35% of net inflows into dollars - more than double the longer-term norm of 14% and 4.5 times the 7.6% share of 2000-02. Yet foreign central banks are already massively overweight dollars. As of year-end 2003, dollar-denominated assets made up about 70% of the world's total official holdings of foreign exchange reserves - more than double America's 30% share of world GDP.

And yet as the US goes deeper and deeper into current account deficit and private investors understandably pull back from taking our paper, we are effectively asking the foreign official community to increase its already massive overweight position in dollars. Locked into mercantilist growth strategies, the Japanese and Chinese see no way out. Just the thought of yen and renminbi appreciation scares them to death.

So they buy ever greater volumes of dollars, subsidising US interest rates and the asset markets they support. US consumers then lever their overvalued assets all the more - especially homes, as you Californians know all too well - extracting new-found purchasing power in order to buy DVD players made in China. What an insane way to run the world!

I know, it's the only world we've got and it seems to be working, for now. Yet I find it the ultimate in hypocrisy and the height of irresponsibility to simply go with the flows and draw comfort in those words "for now". The current account adjustment of a saving-short nation is one of the time-honoured outcomes of global macro. It's just a matter of when, not if. Just because it hasn't happened yet - courtesy of the "kindness of strangers" (aka Japanese and Chinese demand for Treasuries) - doesn't mean it won't happen at any point in the not-so-distant future.

Timing is the trick as you so rightly point it. I am not Muhammad Ali, who can tell you when the "Buck is going to Duck". As the governor of your great state recently put it, I am more of an "economic girlie man", who worries that magic is just about over for a saving-short US economy. With a 5.7% current account deficit - and rising - it's late in the fight. And I'm afraid rope-a-dope won't work this time. Haven't we seen this movie before?

Best always, Steve

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Your sad to see the Ranger's season over analyst,

John F. Mauldin


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Posted 10-04-2004 4:09 AM by John Mauldin