Friday, June 1, 2012

Bill Gross Warns the 1%, Part 1

"The Wall Street Food Chain: Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding a function of central banks as opposed to private investors. Both the lower quality and yields of such debt represent a potential breaking point in our global monetary system. Innovators such as Jobs and Gates are rare within the privileged because the 1% feed primarily off money, not invention. They would have you believe that stocks, bonds and real estate move higher because of their wisdom, when in fact prices float on an ocean of credit, a sea in which all are now increasingly at risk because of high debt and its consequences. Still, as the system de-levers, there are winners and losers, a Wall Street food chain in effect. These economic food chains depend on lots of little fishes. When examining the wealth distribution triangle of land/labor/capital, the Wall Street food chain segregates capital between the haves and have-nots: The Fed and its member banks are the metaphorical whales, the small investors earning .01% on their money market funds are the plankton. Similar comparisons can be drawn between capital and labor. Profits and compensation of the 1% dominate wages of the 99% and the imbalances between the two are as distorted as those within the capital food chain itself. Wall Street and Newport Beach whales like myself don’t have to worry as yet about being someone else’s lunch. Yet the whales' environment is changing – for the worse. The global monetary system which has evolved over the past century, always in the direction of easier, cheaper and more abundant credit, may have reached a point at which it can no longer operate efficiently and equitably to promote economic growth and the fair distribution of its benefits. Future changes may not be so beneficial for our ocean’s oversized creatures. The balance between financial whales and plankton – powerful creditors and much smaller debtors – is dependent on the successful functioning of our global monetary system. What is a global monetary system? It is basically how the world conducts and pays for commerce. Historically, several different systems have been employed but basically they have either been commodity-based systems – gold and silver primarily – or a fiat system, paper money. After rejecting the gold standard at Bretton Woods in 1945, developed nations accepted a hybrid based on dollar convertibility and the fixing of the greenback at $35 per ounce. When that was overwhelmed by U.S. fiscal deficits and dollar printing in the late 1960s, President Nixon ushered in a new, rather loosely defined system that was still dollar dependent for trade and monetary transactions but relied on the consolidated “good behavior” of G-7 central banks to print money parsimoniously and to target inflation close to 2%. Heartened by Paul Volcker in 1979, markets and economies gradually accepted this implicit promise and global credit markets and their economies grew. The global monetary system seemed to be working smoothly. The laws of natural selection and modern day finance seemed to be functioning as anticipated, and the whales were ascendant. Functioning yes, but perhaps not so moderately or smoothly – especially since 2008. Policy responses by fiscal and monetary authorities have managed to prevent substantial haircutting of the $200 trillion or so of financial assets that comprise our global monetary system, yet in the process have increased the risk and lowered the return of sovereign securities which represent its core. QEs and LTROs totalling trillions have been publicly spawned in recent years. In the process, however, yields and future returns have plunged, presenting not a warm Pacific Ocean of positive real interest rates, but a frigid, Arctic sea when compared to 2–3% inflation now commonplace in developed economies. Both the lower quality and lower yields of debt therefore represent a potential breaking point in our global monetary system. Neither condition was considered feasible as recently as five years ago. Now, however, with even the U.S. suffering a credit downgrade and offering negative 200 basis point real policy rates for the privilege of investing in Treasury bills, the willingness of creditors to support the existing system may soon descend. Such a transition occurs because lenders either perceive too much risk or refuse to accept near zero-based returns on their investments. As they question the value of much of the $200 trillion which comprises our current system, they move elsewhere – to real assets such as land, gold and tangibles, or to cash." - William H. Gross