2016-04-10barrons.com

When I started at Pimco in 1971, the amount of credit outstanding in the U.S., including mortgages, business debt, and government debt, was $1 trillion. Now it's $58 trillion. Credit growth, at least in its earlier stages, can be very productive. For all the faults of Fannie Mae and Freddie Mac, the securitization of mortgages lowered interest rates and enabled people to buy homes. But when credit reaches the point of satiation, it doesn't do what it did before.

Think of the old Monty Python movie, The Meaning of Life. A grotesque, rotund guy keeps eating to demonstrate the negatives of gluttony, and finally is offered one last thing, a "wafer-thin mint." He swallows it and explodes. It's pretty funny. Is our financial system, with $58 trillion of credit, to the point of a wafer-thin mint? Probably not. But we're to the point where every bite is less and less fulfilling. Even though credit isn't being created as rapidly as in the past, it doesn't do what it did before.

Central banks believe that the historical model of raising interest rates to dampen inflation and lowering rates to invigorate the economy is still a functional model. The experience of the past five years, and maybe the past 15 or 20 in Japan, has shown this isn't the case.

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In the developed financial economies, as a bloc, lowering interest rates to near zero has produced negative consequences. The best examples of this include the business models of insurance companies and pension funds. Insurers have long-term liabilities and base their death benefits, and even health benefits, on earning a certain rate of interest on their premium dollars. When that rate is zero or close to it, their model is destroyed.

To use another example, California bases its current and future pension payments to civil workers on an estimated future return of 8% or so from bonds and stocks. But when bonds return 1% or 2%, or nothing in Germany's case, what happens? We've seen the difficulties that Puerto Rico, Detroit, and Illinois have faced paying their debts.

Now consider mom and pop and other people who read Barron's. They are saving for retirement and to put their kids through college. They might have depended on a historic 8%-like return from stocks and bonds. Well, sorry. When interest rates get to zero--and that isn't the endpoint; they could go negative--savers are destroyed. And savers are the bedrock of capitalism. Savers allow investment, and investment produces growth.

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What governments want, and what central banks are trying to do, is produce, in addition to minimal growth, a semblance of inflation. Inflating is one way to get out from under all the debt that has been accumulated. It isn't working, because with interest rates at zero, companies and individual savers sense the futility of taking on risk. In this case, the mint eater doesn't explode, but the system sort of grinds to a halt.

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Even in a negative-rate environment, as in Germany or Switzerland, banks and big insurance companies have little choice but to park their money electronically with the central bank and pay 50 basis points. But an individual can say "give me back my money" and keep it in cash. That's what would make the system implode. I'm not talking about millionaires or Newport Beach--aires, but people with $25,000 or $50,000. Without deposits, banks can't make loans anymore, so the system starts to collapse.

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What is the way out? The way out is a little bit of pain over a relatively long period of time. That is a problem for politicians and central bankers who are concerned with their legacy. It means raising interest rates and returning the savings function to normal. The Fed speaks of normalizing the yield curve but knows it can't go too fast. A 25-basis-point increase [in the federal-funds rate] in December had consequences in terms of strengthening the dollar and hurting emerging markets.



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