Market Participant Calls for Keynesian Cure

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

PIMCO, led by Bill Gross, is well respect in the market.  Much of this
repect has been earned by performance.

It is intersting that PIMCO, whose Bill Gross publicly warned about GE,
is now suggesting Keynesian cure for the stalled global economy put in a
box by deregulated free markets.  Some one should also introduce Hyman
Minsky to PIMCO.

Henry C.K. Liu

Below is its latest newsletter:


 Remember the capital market vigilantes? The phrase was popular just a
few years ago in the U.S., when the economy and the stock market were
riding high. The vigilantes were money managers and Wall Street
financial analysts, and they were supposed to usher in a new era of
prosperity.
 The theory was that vigilantes made sure that only worthy projects were
funded. Borrowers - corporate managers and governments alike - would
have to do business the vigilantes' way or their access to capital would
be cut off.

 The "capital market vigilantes" phrase is only a few years old, but its
roots go back to the Age of Deregulation, roughly starting at the end of
the 1970s. Then, and during the 1980s, an intellectual revolution
occurred, at first in the U.S. and UK, then (grudgingly) in Europe. The
idea:
 government bureaucrats do a poor job of deciding which projects should
be funded. So get rid of the regulations, such as interest rate ceilings
and capital controls, that channel capital in particular directions. Let
markets decide instead. Henceforth, in order to secure funding,
capital-spending projects would have to meet strict criteria set by
beady-eyed, skeptical, and unemotional private investors.

 In retrospect, "capital market vigilantes" have a lot of explaining to
do.

 The guardians of capital proved to be less beady-eyed and skeptical
than they should have been. Enron, Adelphia, Worldcom - the list of
male-factors is growing - perpetuated massive accounting frauds under
the noses of fund managers and Wall Street analysts alike.

 Part of the blame belongs to auditors, who may have been ethically
challenged by having lucrative consulting relations with the companies
whose accounts they were supposed to be critically examining. Auditors,
our first line of defense, proved sometimes to be sleeping with the
enemy.

 And some of the blame belongs to Wall Street analysts. The problem was
not just conflicts of interest - investment banks hesitating to
criticize companies that were paying them substantial investment banking
fees - though that was a well known problem. A more subtle problem is
that Wall
 Street analysts depend on corporate managers to provide the 'color'
that makes it easy for an analyst to sound informed and insightful to
his clients. Analysts are loath to 'burn' their sources, which would cut
them off from privileged access to information in the future. So Wall
Street
 analysts write puff pieces instead of tough exposes. Wall Street
analysts, too, were sleeping with the enemy.

 But blaming the U.S. financial mess on crooked corporate executives,
lax auditors, and Wall Street is being too easy on professional fund
managers. We would have had a stock market bubble even if there had been
no accounting frauds, though the bubble might have popped sooner.
 The bottom line is, fund managers bought over-hyped stocks and bonds
based on slipshod group-think, as much as they did based on fraudulent
accounting and Wall Street analysts' fluff.

 During the Bubble years of the late 1990s, many managers lost track of
their guiding star, economic fundamentals. Rather than searching for
fundamentally cheap securities, fund managers opted for the latest fad
and fashion. Often, the game was to try to anticipate what fads other
investors soon would be falling for - the New New Thing - and then to
get there first. In other words, many 'investors' became traders,
substituting psychology, market technicals, and superficial claptrap for
economic and financial analysis in choosing their portfolios. Why?
Sometimes fund managers were just masking incom-petence - managers who
did not have the fundamental analytical skills fund managers should
have. Sometimes it masked simple laziness - it was easier and more fun
to spend your days talking to fawning security salesmen, and opining on
the latest fads and fashions in the securities business, than it was to
roll up your sleeves and run some numbers, or to think originally and
deeply about investments and markets.

 Some managers were easily seduced by analysts, the Sirens of Wall
Street. The Street does not profit when a money manager is successful in
finding undervalued securities. The Street profits from trading volume.
Wall Street analysts act like shills, encouraging managers to bet often,
not necessarily to bet wisely. They stroke fund manager egos, exchange
rumor and innuendo in the guise of news, and encourage the illusion that
managers are being sophisticated and shrewd when they trade on gossip
and short term technicals. Self interest played a part, too. Some fund
managers could see what was happening, so by the end of the '90s the
U.S. stock market had become a game of musical chairs. Managers with
wisdom and experience knew the music would stop some day, and warily
watched other managers for signs they were getting ready to grab a chair
and sit the next one out. But nobody would sit down first, for fear of
losing business to less honest or less astute competitors.

Finally, if you ask U.S. fund managers why they traded on rumor rather
than investing on fundamentals, they will tell you it was because their
clients had such short time horizons that managers could not afford to
wait for true value to become apparent. In other words, managers
protest, they were traders because the clients demanded traders, not
investors.

Market manias have become a recurring feature of the financial
landscape. During a mania the markets throw cheap capital at somebody.
Cheap capital destroys value.

Cheap capital destroys capital because when capital is cheap there is no
need to husband it. Capital markets ration capital by discriminating
between good investments and bad ones. The key is not just to finance
the good ones, but also to spike the bad ones. When capital is nearly
free, even bad ones find backing.

During the late 1980s, Japanese companies got cheap capital. They
destroyed value instead of creating it. The ultimate result was the
crash of the Japanese stock market and then the lost decade of
non-growth for the Japanese economy.

During the early '90s, developing Asian countries got cheap capital. So
they, too, destroyed value rather than creating it. The result was the
Asian financial crisis of 1997.

During the late 1990s, U.S. tech companies got cheap capital. And they
destroyed value rather than creating it, too. The ultimate result: the
NASDAQ collapsed.

So what next? John Maynard Keynes, perhaps the most influential
economist of the 20th century and himself a successful speculator, was
skeptical about the rationality of capital markets. He warned that
society is not well served when business investment is governed by a
casino. America's financial crisis may blow over during the next few
months, but what if there are many more Enrons yet to be uncovered; or
if the crisis in confidence in corporate America means stock prices keep
falling well past fair value; or if the current capital market debacle
drags the U.S. economy into a lost decade of no growth? Then expect to
see demands that the capital market vigilantes cede some of their power
back to the government. In short, expect to see a backlash against
financial deregulation in the U.S.

 Dr. Lee R. Thomas, III
 Managing Director, PIMCO