In a recently published report entitled "Wounded Heart," Bill Gross offered a really bizarre diagnosis of certain problems in America's financial system and economy - complete with all sorts of muddled medical metaphors.
Fortunately for Mr. Gross, and all of us that provide commentary on economic and financial affairs, people cannot be prosecuted for malpractice for merely expressing opinions. However, I do believe that ideas have consequences. And, for this reason, I am concerned that the faulty analysis propounded by Mr. Gross in the aforementioned essay (and subsequent follow-up media appearances) could gain currency amongst economic and financial analysts and/or the public at large.
Thus, in my most recent article published on Seeking Alpha entitled "Bill Gross's Dreadful Analysis of America's Wounded Heart," I demonstrated that the central thesis in Mr. Gross's report was clearly wrong on both empirical and conceptual grounds. I strongly encourage readers to review this prior article. In the present article, I will review an additional bevy of misguided arguments offered by Mr. Gross in support of his central view.
Gross And His Five Central Bank-Induced "Coagulants"
In support of his central argument, Gross cites five "coagulants" that are damaging America's financial and economic system:
1. Savers deprived of income, economy suffers. According to Gross, "zero-bound yields deprive savers of their ability to generate income which in turn limits consumption and economic growth." Narrowly construed, this claim is in and of itself unobjectionable. But from a macroeconomic point of view, the claim is demonstrably false. This becomes apparent when one recognizes that the returns on credit are largely a zero-sum dynamic. Every dollar of additional accrued interest that goes into the pocket of a creditor is a dollar of purchasing power that exits the pocket of a debtor. Thus, if savers earn more yield on their savings, the debtors (e.g. consumers and entrepreneurs) will have less disposable income to consume and invest.
Ironically, the US as a whole may be a net beneficiary of this situation since much of the aggregate debt in the US is actually financed by foreign creditors. So, on an aggregate level, foreign creditors are negatively impacted from low interest rates in the US, while US citizens are actually benefiting.
Furthermore, under economic and financial conditions characterized by high risk-aversion and high liquidity preference, there tends to develop a divergence between savings and investment - i.e. not all savings is transformed via credit intermediation into consumption and/or investment. One implication of this same set of conditions is that when risk aversion is high, favoring savers with higher interest rates will not help the economy -- precisely because little or none of the windfall will be transformed into consumption or investment. By contrast, lowering interest rates for debtors will increase the disposable income of a cohort that on balance will be more inclined to turn the windfall from lower interest rates into economic activity-generating expenditure.
Therefore, Gross's claim that low interest rates are currently harming consumption, investment and real economic activity is wrong for two reasons. First, low interest rates benefit the US economy because American debtors pay less money to foreign creditors and retain more disposable income to spend in the domestic economy. Second, low interest rates favor debtors, and this will typically provide a short-term aggregate boost to the economy due to the relatively higher marginal propensity to consume of debtors relative to savers.
2. Destroys financial companies. Bill Gross thinks we need to feel sorry for financial institutions and their employees:
Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient "carry" to support employment infrastructures, then personnel layoffs quickly follow. With banks, net interest margins (NIM) are lowered because of "carry" compression, and then nationwide retail branches previously serving as depository magnets are closed one by one.
Poor bank shareholders and employees! They are not making enough money!
All kidding aside, the problem that Gross is citing might actually be a serious issue - if there was any substantial merit in what he was saying. First of all, I have already pointed out in the previous essay that the carry that financial institutions such as GE Capital (GE) enjoy right now is quite high. They are borrowing funds at or near 0% and lending it out at relatively high spreads. This means that they are making money hand over fist.
On this point, I would like to highlight a confusion regarding the relatively low Net Interest Margins being currently earned by banks. Mr. Gross and other analysts have surmised from this statistic that banks do not have adequate incentives to assume risk and fund investment in the real economy. This evinces a fundamental misunderstanding of credit and interest rate formation. NIM measures the spread between a bank's cost of funds and total earning assets. For purposes of Gross's argument, NIM is a deceptive metric, because it is being hugely impacted (negatively) by the massive amount of assets that banks have invested in Treasury securities and in excess reserves deposited at the Fed both of which produce NIM of near zero.
It is clear that it is not Fed policies that have caused banks to choose to invest such massive amounts of funds in Treasuries and/or excess deposits at the Fed. To the contrary, Fed policies have explicitly encouraged banks to invest funds in riskier investments. When one focuses in only on the carry earned by banks on consumer and business credit, it is clear that the lack of carry on the current portfolio of such assets is not the problem; there is no lack of incentive to invest in these existing lines of business. The problem is that the private sector in the real economy is not generating enough incremental sources of profitable investments for entrepreneurs to attempt to capture and for banks to finance. And this in turn has to do with debt-inhibited consumption growth in the household sector and insufficient productivity enhancements in the business sector.
To argue that central bank policies are discouraging lending to the private sector is not only exactly wrong, it is to put the cart before the horse. In a healthy economy, when incremental profit-making opportunities for entrepreneurs are abundant, there emerges a healthy competition for funds, which causes a rise in the rate of interest that can be earned by savers. The problem at present is that there is a massive imbalance between available liquidity (which currently exists in excess) and meager profitable opportunities for incremental growth that exist in the real economy.
As a result of this excess supply of financial capital relative to effective real-economy demand, yields on financial investments are low. The consequence is that financial investors are essentially being "forced" or "lured" by central bank policies to take too much risk -- not too little risk, as claimed by Gross.
Therefore, it is not that current yields are not profitable enough to incentivize risk-taking by financial investors - it is that there are not enough profitable opportunities for incremental investment in the real economy to justify the risks being assumed by financial investors. The excess risk-taking by financial investors and traders is most clearly seen in the record issuance of junk bonds (JNK) as well as the all-time low yields on these risky assets. Furthermore, the frenetic rise of stock prices represented by the spectacular performance of the S&P 500 index and index ETFs such as SPDR S&P 500 (SPY) is further evidence of heightened risk-taking being encouraged by Fed policies.
By the same token, the lack of underlying revenue and profit growth being reported by S&P 500 companies (currently about 1%) highlights the imbalance between real economy profitability and financial markets risk-taking that I am referring to.
Second, it is true that profitability at banks such as Bank of America (BAC) have not been restored to previous peaks, but that is not a problem per se - it is symptomatic of a problem that is getting cleaned up. Bank profitability, though currently on the rise, is still below previous peaks in part because banks are still creating loan-loss and equity reserves to cover for losses suffered by the bad decisions that led to the 2008 financial crisis. This creation of reserves is a positive development for the banks and for the US economy. Furthermore, profitability and employment in the financial sector is being negatively impacted by the need for "right-sizing." Many banks and insurance companies such as MetLife (MET) had built up too much capacity to sell too many financial products to consumers that could simply not afford them. This right-sizing is ultimately a good thing for the economy and has nothing to do with QE and zero interest rate policy. Thus, the claim that Fed policies are somehow hurting the economy by crippling the financial sector is not sound.
3. "Zombie corporations are allowed to survive." It is certainly true that some companies would not be in business but for the unsustainably low interest rates that currently prevail in the US. But how is it that raising interest rates and driving these corporations to shut down is going to help the economy? The answer is that it is not. The economic losses sustained by the failure of zombie companies are, indeed, inevitable. But the issue at hand is one of timing. It may make more sense from a policy standpoint to allow these firms to fail when the rest of the economy is booming and generating sufficient employment demand to absorb the laid-off workers of zombie firms. Thus, while Mr. Gross may be right tomorrow, he may be wrong today. A sound policy applied at the wrong time is a wrong policy.
4. "Low ROIs in the real economy lead corporations resort to financial engineering as opposed to R&D and productive investment." Mr. Gross argues that Apple (AAPL) and other companies are engaging in share buybacks and paying dividends rather than investing in the real economy. Again, as I explained in my prior essay and in point #2 above, Mr. Gross is confusing the rate of return that businesses can obtain from investment in the real economy and short-term interest rates controlled by the Fed. They are not the same thing at all. The former is a product of consumer demand and productivity growth - which, if anything, are positively influenced by low interest rates. All things being equal, ROI obtained by entrepreneurs in the real economy will clearly decline as a function of higher interest rates.
Let me be clear. Rising interest rates are certainly compatible with accelerating economic activity. Indeed the two things tend to be correlated historically. But rising interest rates are not the cause of accelerating economic activity. To the contrary: Sustained acceleration of economic activity is what drives any sustainable rise in interest rates.
5. "Credit expansion in the private economy is restricted by an expanding Fed balance sheet and the limits on Treasury 'repo'." Gross says that this issue is "too complicated" to explain to his readers. But he does offer readers a snippet of summary explanation:
"The ability of private credit markets to deliver oxygen to the real economy is being hampered because most new Treasuries wind up in the dungeon of the Fed's balance sheet where they cannot be expanded, lent out and rehypothecated to foster private credit growth. I have previously suggested that the Fed (and other central banks) are where bad bonds go to die. Low yielding Treasuries fit that description and once there, they expire, being no longer available for credit expansion in the private economy."
Fortunately, this short explanation offered by Mr. Gross is all we need to understand that his entire argument in this respect is spectacularly unsound. Mr. Gross is suggesting that Treasury bonds can be used and reused as collateral by financial markets participants, enabling cascading credit and money creation. That is true. But this begs a more obvious point: The fact of the matter is that the Treasuries that the Fed is purchasing and taking out of circulation are being swapped for cold hard cash that is being introduced into the market in their place. And cold hard cash is, by far, the best collateral in existence; it is the high-powered asset that enables more credit creation than any other. So, this argument about the contractionary impact from withdrawal of Treasury bond collateral from the financial system is bogus.
Now, it might be argued that in the distant future, the Treasuries that the Fed has bought will mature, or "die there," as Gross put it, causing net redemptions that will result in cash being withdrawn from circulation. But as an argument denying the stimulative effects of QE, this statement is utterly illogical. If withdrawal of QE from future redemptions is argued to be contractionary for the economy in the long-run (i.e. withdrawal of cash from the economy via redemption of Treasuries upon maturity), it follows logically that introduction of QE itself must be expansionary for the economy in the short run (i.e. injection of cash into the economy in exchange for the withdrawal of Treasuries).
Any way you look at it, the injection of money into the economy in exchange for withdrawal Treasury bonds has been stimulative to the economy, on the margin. We can argue about how much or how little the economy has actually been stimulated by this type of asset swap. But what we cannot logically argue is that this monetary injection has been economically contractionary.
Anybody can have a bad day. "The King" Lebron James once shot three air-balls in an NBA game, yet he is still a shoe-in for the Hall of Fame. Similarly, "The Bond King" Bill Gross can publish as many bloopers in his PIMCO Investment Outlook as he wants, and his place in the all-time pantheon of investment greats will remain secure.
Fortunately, we can sometimes learn more about a particular field of discipline by studying the errors committed by masters than by scrutinizing the work of those with less skill. For the contrast between virtuosity and folly, when they are observed in the work of the same practitioner, can help to sharpen our capacity for discernment.