Odd Lots - Paul McCulley: We Are "Unambiguously" On The Verge Of A Profound Change In The Economy

Episode Date: September 3, 2020

Paul McCulley is a former Managing Director at PIMCO and a legend of the industry, having helped coin phrases such as "shadow banking" and the "Minsky moment." On this episode, we discuss the history of economic policy ideas, starting with the monetary and supply side revolutions roughly forty years ago, and how they've dominated thinking until today. But the break is coming. He says that we are "unambiguously" on the verge of a profound change to a more democratically managed economy (one more driven by fiscal policy), a change that will have significant changes for the real economy as well as markets and portfolio management.See omnystudio.com/listener for privacy information.

I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets, from corporate law to constitutional law, and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars and policy experts to break down what the rulings really mean. We do this every weekday,

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this podcast for years, and it kind of seems crazy that we'd never talk to them before. Isn't it a brag? One day we're going to get Jerome Powell on the podcast and we'll say, you know, like, we were thinking of having you on. You were such a natural fit. I can't believe it took this long. But yes, you're absolutely right. There are people, well, there are people who, you know, everyone talks about. And I am going to say that. I love that. I was like, how did we not think to have Powell on before? I love that. Sorry. There are people out there. who have had a big influence in markets and who consistently think about and write about the subject matter that all thoughts concerns itself with. And there are still some that we haven't had on the

podcast. This is true. Right. So obviously very excited about today's guest. We're going to jump right into it. He's a former managing director at Pimpco. He is the coiner of the term Minsky moment. He even coined the term the shadow banking system, currently a senior fellow, currently an adjunct professor at the McDonough School of Business at Georgetown University. We are going to be speaking to the economist and investor Paul McCulley. I'm really excited about this conversation. So Paul, thank you very much for joining us. Thank you very much, Joe. Paul, I listened to her speech you gave last year at the Levy Institute. And one of the things, the sort of main theme that you identified is that over the last,

you know, roughly 40 years, we've had these sort of big turning points, not just in sort of business and market cycles, but it's sort of idea cycles and policy cycles. So the late 70s, the rise of monetarism, supply side policies under Reagan, monetary policy dominance under Greenspan and Bernanke. And so the big question, and it's a big thing that Tracy and I have been talking about a lot lately, is are we at the cusp of a sort of new policy regime? The short answer is unambiguously, yes. And I want to stress unambiguously, yes. For the last 40 years, essentially we've been in a monetary policy dominant world, and it's ebbed and flowed depending upon the cycle, but it has been clearly a world where monetary policy was the

dominant lever in the monetary physical policy mix. Sometimes, you know, the phrase was used the only game in town that the Fed could fix anything, and therefore the Fed should fix anything, and the Fed should be in charge and that actually the Fed should be de facto the fourth branch of government because that's where the adults were and they could make technocratic good decisions. And this messy thing called democracy, which was in charge of physical policy, could be pushed to the side, paid attention to as necessary, but that we were living in a monetary policy. dominant world, which also would be a world in which effectively capitalism would be superior

to democracy and the daily ebb and flow of economic policymaking. What do you think makes this crisis different, or maybe if I phrase it a different way, why do you think that change is coming now in particular? Because we had people, you know, writing and talking about the breakdown in the church and state separation of fiscal and monetary policy back in the 1980s. So why now? Actually, it's interesting that you mentioned the 1980s because that's essentially when the church and state separation became very solidified as in almost a wall, if you will. In fact, I think back to 1980, I was actually in graduate school. I was in New York at Columbia in 1980 when I graduated in

1981, which was not the most fortuitous time to graduate from business school. But that's when Paul Volcker was establishing essentially monetary policy dominance. In fact, Mr. Reagan had run on a policy of supply-side tax cuts, which were a Trojan horse for tax cuts for the rich. It was for not, essentially, until Volker finally relented from monetary policy. dominance and then you saw the effect come through in the recovery of the 1980. So I think the church and state separation between monetary and fiscal policy really is rooted in the epic turn 40 years ago. And it's moved back and forth over time depending upon the cycle.

But I take on your point very much with respect to a decade ago. when the church and state separation was softened quite dramatically by necessity, or as the Fed would like to say, by exasency with the financial crisis, because we hit the zero bound for policy rates. And the moment you hit the zero bound for policy rates, then almost definitionally you will change the paradigm of monetary policy rates. dominance, and we had that big experiment, if you will, of monetary and fiscal policy cooperation back in the period following the financial crisis. But then once it was over, or not over, but had reached beyond its crisis proportions, then effectively there was a morphing back to the whole notion that we need to normalize the central bank's balance sheet, normalized short-term interest rates. And of course, you also had around the same time the advent of

the Tea Party, which wanted to normalize, if you will, budget deficits. So conceptually, we could have had this epic turn a decade ago where we would have moved to a regime of full fiscal dominance. But we resisted it as a society, I think very much to democracy's regret. That was a decade ago. But now, I think any pretence is over and we're clearly in a fiscal policy dominant world. And I say that with incredible admiration for the Federal Reserve. And I stand in awe in many respects of Chair Powell and his willingness is to recognize. the fact that facts on the ground had changed, particularly with the nature of this pandemic, and that we clearly need to be in a physical policy-dominated world.

And the Fed will be highly supportive, and I would also say subordinate. So I want to talk a little bit about the framing of this discussion, because you said something very interesting, I thought, at the beginning, that talks about this in a slightly different way than most people. So we talk about this idea of like some handoff between, okay, the Fed is going to be our primary engine of stability and now there's some handoff to fiscal policy. But you frame it a little bit differently, which is more the handoff from a sort of walled garden secluded temple of people working in the Fed to a handoff to democracy.

And this is a point that actually Tracy has made a bunch that as we talk a lot about sort of new regimes, MMT ideas and so forth, these ideas are inescapable from politics. They're downstream from politics. You can't technocratically implement fiscal policy. Talk to us just sort of about the framing of thinking about this as the reassertion of democracy in managing the economy. That is a profound question. I've written major papers on it and given way too many speeches on it over the years. And we live very much in a mixed economy. And capitalism are market-based economy and democracy are fellow travelers. And in many respects, they are a holy marriage of, incompatibility in the sense that both democracy and capitalism are governance systems, but they're distinctly different in that democracy at its core is a socialist governance system. And I don't say that pejoratively. I say that descriptively because you think in terms of the power of democracy is one person, one vote, each with inalienable rights. That sounds like socialism to me, and it sounds really, really good. So democracy is inherently founded on a socialist distribution of power, all people

are created equal. So that's a governance system. And then capitalism is also a governance system, but is the antithesis of socialism in the sense that it is a cumulative voting system. Not all are created equal under the banner of capitalism. It's the matter of the more dollars you have, the more votes you have. It is fundamentally a cumulative voting system. An example I frequently use when I'm giving speeches and so forth, is the decision when you get onto an airplane, whether or not you get one of the big seats

or you get one of the little seats, or, you know, go left on the plane or go right on the plane is a capitalist decision. And it's based upon cumulative voting. If you want to have one of the big seats, you have to have a lot of votes, otherwise known as dollars. And there's nothing wrong with that.

system. It's a market-based system, but it is categorically not predicated on the notion that all citizens are created equal. It's founded on the notion that the more dollars you have, the more power you have. So we live in a mixed economy of capitalism and democracy, and they're supposed to be in conflict all of the time because they're fundamentally different. But the tie that binds them is fundamentally the rule of law. Because capitalism requires an enforceable rule of law. And an enforceable, credible rule of law is the one thing that capitalism categorically cannot do for itself. So democracy's gift to capitalism is a rule of law. And democracy's gift to capitalism is a rule of law. and democracy can do a credible, enforceable rule of law grounded in justice.

And that is a true gift of democracy to capitalism. So I think both can flourish. I think this tradeoff that we hear about all the time, democracy versus capitalism in many respects is a false tradeoff because they have to co-exist. They need each other. Capitalism needs an incredible rule of law, and democracy needs efficiency.

And capitalism is a master at efficiency. You win or you lose based upon whether or not you're smart or dumb. So I think what we're evolving too is a better, more sustainable, more just mix between democracy and capitalism. That was a really long-winner answer to your question, but I'm quite passionate about this. The news doesn't stop on the weekends. Context changes constantly.

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Television, radio, and wherever you get your podcasts. Just on the intertwining of monetary with fiscal policy, what downsides do you see, if any? And I'm thinking back to, you know, when Congress was debating over stimulus measures, the additional unemployment checks that took a really, really long time. And there's a lot of criticism of that process. And meanwhile, the Federal Reserve acted fairly quickly to address market turmoil back in March. What do you see as either negatives or tradeoffs in the mix of fiscal with monetary policy? Monetary policy can be very efficient. And there's a very simple reason for that is that it is one step removed from the sausage-making of democracy. That's why we have political independence.

There's a mandate, obviously, from Congress, which created the Fed. The Fed's not the fourth branch of government. There's a mandate, the full employment and price stability mandate. but as a practical matter, the Federal Reserve can move very, very quickly because the decision-making process is not subject to the vagaries of democracy. And also, it can have a very, very quick impact because essentially the central bank becomes the marginal player or the price-setter across the entire array of finance. conditions. So monetary policy can move very, very quickly and can actually have a profound effect on financial conditions. What monetary policy can't do efficiently at all is to channel the horsepower of the money monopoly to Main Street. It is always a bank shot.

through Wall Street and financial conditions. And so monetary policy has the benefit of incredible efficiency, but it has the liability that it can't get to Main Street directly, and Main Street is the home of democracy. And once you hit the zero lower bound, and the reason we've hit the zero lower bound is because the Fed, failed, and here I'm not criticizing the Fed, I'm just making an observation, the Fed failed to ever in the last 10 years achieve its inflation target. So therefore, there was very little space to ease

interest rates in your traditional sort of way to stimulate private sector borrowing, you know, housing, cars, all of that sort of stuff, things we learned in school about, you know, how does monetary policy work on Main Street. It wasn't out of ammunition once it hit zero, but once you hit zero, effectively you have to become a partner of the physical authority. So when you ask the question about downside, I think the big downside of too much central bank independence, and I think we've certainly had it. And really in this century, because it goes back to prior to the financial crisis as well. If you have too much central bank independence, then effectively that becomes the sole

tool of overall economic policy and monetary policy works through markets. And by definition, stimulating the economy or supporting the economy with monetary policy alone is going to dramatically exacerbate income and wealth inequality, which is an anathema to the spirit and the justice of democracy. So that's the downside of leaning too heavily on monetary policy is that you end up going against a fundamental tenant of democracy. Because monetary policy works by driving up asset prices. And lo and behold, rich people own assets. That's simple.

Every answer you've given me like five ideas for questions. But I have a simple one. And it's one that we recently, we were talking to Vitor Constancia, former ECB vice president. Do we know what causes inflation? I mean, you talked about the Fed failing to hit its inflation goals. But A, do we have a confident theory of what causes inflation? inflation? And does the central bank actually have the tools to hit its mandate?

Fascinating question, Joe. In fact, Chair Powell has commented on this issue, and a lot of people have as well, is that we really don't have a robust theoretical framework for what determines inflation anymore. I mean, the workhorse for my lifetime, probably before that, too, was the Phillips curve. And essentially, the Phillips curve has flattened dramatically. So that tradeoff between resource utilization, as the Fed would say, and inflation has broken down dramatically. So the short answer is, I don't think the Fed or my profession has a good way. workable theoretical framework for inflation anymore. And that is really a big, big issue

when you think in terms of central bank independence, which I think some degree of it is always necessary for efficiency. But if you don't have a good workable theory on what determines inflation, then it is a very dangerous, proposition to lean too heavily on the central bank as your only game in town, because central bank independence theoretically is to cut off the risk of democracy's inherent inflationary bias on the whole notion that democracy involves elected officials who would always like to

have the economy hotter rather than slower, who presumably would always like to spend more than they tax, who presumably would have a chronic systematic tendency to overheat the economy, which would therefore lead to inflation. So the crazondiattra of central bank independence is to cut off the fat tail of inflation because democracy through the electoral process inherently has a pro-inflation bias. And that's not a majority, but it's just inherent in the structure. The last presidential candidate who tried to run on a platform of increasing taxes didn't do terribly well in 1984.

So the reason for central bank independence and the isolation from the political process, or as I like to refer to it as the de facto fourth branch status, is to do that which democracy can't do or the physical authority can't do, which is say no and actually keep the economy for. from running hot. So that really is the foundation for central bank independence. And you would see that in Europe very much as well. But if you end up in a world where actually the fat tail that you're dealing with is not too hot economy generating inflation, but a too cold economy and also a fat tail risk of deflation, then your fundamental argument for rigid central bank independence no longer holds. And I think the whole world is experiencing that reality.

And here, I'm not criticizing central banks, and particularly not the Federal Reserve, but the world changed in part because of our 40-year love affair with capitalism and globalism and the demise of unions and all sorts of other sort of things, and that we found out you can run this economy with an incredibly low unemployment rate and have no inflation echo whatsoever. So that's the configuration of secular forces, long-lasting forces that have brought us to this juncture. And all the things I just said were in place before the pandemic hit. So these are not new things.

It's just once the pandemic hit, then it put them into technicolor in a way that was beyond imagination prior to the pandemic. Capitalism has always had a very dark underbelly. And I'm a capitalist, so therefore I'm not criticizing capitalism. I am just saying it has a dark underbelly because it is a cumulative voting system. The more dollars you have, the more votes you have. And if you have robust, full-throated cowboy capitalism, it is inherently, I think, disinflationary, deflationary for Main Street and is also going to skew your income and wealth distribution

in a very anti-democratic sort of way. In fact, when you ask the question from a standpoint of a good workable theory of inflation, I think where we're going to be morphing to over time is that a working model of inflation, this is not something that you can specify necessarily econometrically, is that inflation at the end of the day is going to reflect the relative pricing power of capital versus labor. And capitalism obviously has had the dominant role in power in our economy. if capital is the dominant power in your economy versus labor, you will tend to have a disinflationary environment. You will have an environment where also you will drive corporate profit margins

to generational highs as a share of national income. And Wall Street will absolutely unambiguously love it. In contrast, if you switch to labor, which can also be called the citizens of democracy, that labor has relative power versus capital, then you will tend to see a bias towards higher inflation, lower shares for corporate profits relative to national income. and more chickens in Main Street pots. What does that, what does the dominance of deflation mean for the Federal Reserve's mandate? For instance, like, could you see a scenario where they start targeting wage growth instead of something like full employment?

Or, I guess to put it in other way, if you were running the Fed, what would you be targeting at this juncture? Kind of hard for me to think in terms of that, that last construct. But I don't envision the Fed targeting wages per se, but I do think that the Fed has and will look at wages as a measure of whether or not the economy is fully employed. and given the fact that they've lost the ability to specify the Nehru or the natural rate of unemployment, and here I'm not, again, I'm not criticizing the Fed. It's just a fact that they have spent the last decade revising down their estimates of the natural rate of unemployment.

I think very prudently the Fed will quit trying to operate with British. precision, you know, is the natural rate of unemployment 4.7 or 4.4? Joe, I'm sure you remember all of these debates, you know, exactly where Nehru is, and particularly following 2012, when under Ben Bernanke's leadership, the Fed started publishing its estimate of Nehru and then spent the next eight years revising it down every year. I think where the Fed has evolved, too, very appropriately, and here I will be the first and the last man in the room of plotting, is rather than a bunch of wunks trying to figure out where Nehru is, is let the data tell you where it is, which another way is saying is let the tightness

of the labor market, which is presumed to be. a arbiter of inflation, actually tell the story. No, presume the outcome, let the data tell the story. Well, let me ask you a question because, and just bringing it to monetary policy right now, because one thing that's striking, thinking about today in 2020 versus the crisis aftermath in 2009 is markets in 2009 expected the first rate hikes or sort of normalization to come soon. And some people thought in early 2009 we would get rate hikes by the end of 2009 or early 2010. And instead, the first rate hikes weren't until like 2015.

Now the market seems to have this appreciation that even if we were to get, say, a CPI spike in the short term, that the Fed would look through it and it's just not in a hurry at all to hike rates. And so I'm curious, A, is this progress, this sort of idea that the Fed isn't going to be so perceived to be so aggressive in fighting inflation if it picks up? A is that progress. And B, is it effective? So will we see a more robust recovery than we saw last time because of this perception that the Fed would be willing to let it run hot while it looks for real signs of labor market tightness? Yes and yes and yes, I think, if I got the order of your question. Sorry. I know it's packed a bunch of no, no, no, no, no, no. This is great fun. This is what I do.

And I think that we as a society and the Fed very, very much as an institution, learns from experience. And learning that the Phillips curve has become flatter than a pancake is a excellent. is an existential piece of information that the economy can be more fully employed than previously thought, as in the last previous 40 damn years. I think that's very much where the Fed's mindset is, is they are politically independent to fight inflation, but that war has been won and over one, so therefore they should have a very cooperative approach with the fiscal authority. Their job is not to say no.

Their job is to say yes. Their job is to say yes to bigger budget deficits. That is their job. And in fact, Jay is saying it every day in subtle ways and increasingly less settling. God bless him for being less subtle. about it because we so desperately need robust physical policy relief and support for capitalism because of the unique nature of the pandemic, as well as all of the social injustices that were exposed by the shock of the pandemic.

So yeah, I think the Fed has learned a huge amount. And actually, I think the political establishment very much has learned a lot as well, is they have a whole lot more degrees of freedom to act in a proper democratic fashion and not have to worry about being slapped on the risk by the monetary authority. So, yeah, I think we've learned a lot as a society. I think we've learned a lot with respect to the institutions of economic management. And I think we as society are also re-learning the core tenets of democracy, which is for citizens not just to have one person, one vote, and in a liberal rights as concepts,

but actually to live those propositions in the making of policy. And actually, one of the things that's been delightfully surprising to me is just how quickly the congressional center of gravity has moved to recognizing these propositions. I mean, I think they would have recognized them over time because the political process is fed up with income and wealth inequality, which I consider to be the proximate cause of the fact that Mr. Trump's in the White House. So I think we would have gotten there over time. I would call it Democratic Enlightenment, Small D Democrat Enlightenment,

but the pandemic has really driven home. We don't have time to do this in the fullness of time. we need to do it right now. And naval gazing about the long-term consequence of budget deficit is no longer the parlor game in Washington. And I consider that to be a delightful moment in history. The budget deficit is quite big enough to take care of itself and needs to be bigger. Just on that note, should the Fed measure fiscal space?

That's a fascinating question. absolutely right, and actually come up with a analytical framework by which Congress could be guided on how big the budget deficit should be? Is that what you're referring to? I'm not sure. I've never been asked that question before. Yeah, I think that's right. I was going to say, if we agree that fiscal space might be bigger than we imagined before, then is there a role for the Federal Reserve to try to gauge that and maybe help Congress in figuring out how much there is and how it might be best deployed? That is really a great existential question. I certainly think that the Fed should be very cooperably involved and analytically. So with the fiscal authority

and trying to figure out the answer to that question because we really don't know the answer. But I don't think that the Fed should take it further to the point where effectively they would say to the physical authority, based upon our best modeling work and all of this sort of thing, that you have ex-allowance to, run budget deficit. I don't think the Fed wants to go that direction. I don't think the Fed should go

that direction of effectively giving the fiscal authority an allowance to exercise democracy. That would be reminiscent of effectively Paul Volcker and Alan Greenspan effectively telling Congress what to do. and if they didn't do it, then there would be consequences. So I don't think that the Fed should establish the moral equivalent of the FOMC for fiscal policy. Now, that's a fascinating angle of thought, however, in that should Congress itself have the moral equivalent of an FOMC, and that's an idea that I think is very intriguing and certainly doesn't originate with me whatsoever. In fact, a guy who wrote effectively a book on that concept was Alan Blinder over a decade ago. If we're going to have monetary policy, have a demonstrable, technocratic, or wonky sort of body to debate and determine these sorts of things.

Maybe there should be something equivalent over on the congressional side that sets fiscal policy because you've got a huge body there that's not an efficient way to make these sorts of decisions. So I would certainly be supportive of Congress establishing something that would have similarity to the F on C to deliberate in a technocratic way, informed by politics and so forth, but actually informed analytically on determining, you know, how much fiscal space there is. You know, kind of like, you know, the FOMC is always, you know, focused on what is Nehru? What is Nehru? What is Nehru?

And then everything shifted to what is our star? what is your natural real rate of interest. So I would be very open and supportive of Congress having a body that would, you know, deliberate about these sorts of things and inform the elected officials. In fact, conceptually, you could morph the CBO in that direction. Here to force CBO has tried to, you know, essentially say, we'll just bottle out the implications of policy proposals and what it means for the budget deficit and all that feedback loop into pay-go and pay-forwards and all of that sort of stuff. So conceptually, you could take the CBO and turbo charge it into the moral equivalent of the FOMR. And again, Alan Blinder is a brilliant man as some really long-standing viewpoints on that.

And I would hardly recommend that you have him on. I'm Francie Lacqua, an award-winning journalist. And I've got a new podcast, leaders with Francine Lacqua from Bloomberg Podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision.

Listen to new episodes every other Monday. Follow leaders with Francine Lacroix wherever you get your podcasts. I want to shift the conversation to actual markets and investing for a moment. As mentioned, at the beginning, you're a managing director at PIMCO. And this whole environment, these last 40 years, I mean, it's clearly just been fantastic for investors. If you just bought stocks, sure, you hit a few scary months here to there, but by and large, they've just gone up. If you had a balanced sort of classical 6040 portfolio, you've done phenomenally well and less volatility because of this sort of way we've crushed inflation. But if you're thinking, like, sort of like from a portfolio management hat on, and you think, okay, we've come to the end of all these trends.

As you say, we're going to have this shift. then how what does that mean for sort of traditional portfolio allocation and risk management and will the ideas that worked over the last 40 years are they are people going to have to come up with new ideas if the ideas that have worked over the last 40 years work going forward then democracy has failed and i say that with great convictions nay passion. If what has worked in investment management for the last 40 years were to continue working not immediately today or tomorrow the next day, but if it were to work on a secular basis for the next five years, 10 years, 20 years, then we have unambiguously failed as a democracy.

because the reason the financial markets have done so spectacularly well over the last 40 years is because we've been in a 40-year disinflationary environment. I mean, you've had your cyclical ups and downs, but unambiguously, we've had 40 years of disinflation. And that's because, effectively, we shifted power in our economy, both domestically and globally, from labor to capital. And capital has had the dominant influence in our economy for the last 40 years. And globalization is simply capitalism on a global stage, disinflationary environment because of the dominance of capitalism will also give you a fall over time

in our star, that real natural interest rate. It will also tend to dampen volatility. So when you think in terms of the three big forces of the last 40 years that have made your old 60-40 thing look wonderfully well, those three forces. is what drove it, is the supremacy of capitalism over democracy, disinflation, and a falling natural real interest rate. And you can just, I love teaching this to my students, you can plug all three of those into a Gordon formula, here I mean to be testing you know, days ago from MBA school, but it's a really simple proposition of how you value things. And the Gordon formula is $1. divided by the risk-free interest rate minus the growth rate of profits plus a risk premium.

And we've had a 40-year tailwind of effectively falling real interest rates, which by definition is going to increase the market value of all income streams. and that's what capitalism is about is ownership claims on income streams. So actually, it's been 40 years of an incredible run bull market in valuation for financial assets. And I certainly hope as a citizen that is not repeated. So I think my old profession, I'm retired now. I don't manage anybody's money but my own. I mean, I really hope that my old profession figures out a new paradigm for its own health,

because what's worked the last 40 years should not work unless you want democracy to fail. Okay, the old approach, the old 6040 won't work. Is there something that will work in the new system? If democracy works, Are there portfolios that can still work if we have this, you know, reassertion of democratic economic management? Actually, I'm not so much critical of the 60-40 proposition. It's the payoff of the 60-40 proposition.

The rate of return, actually, I don't know what the right number is going to be going forward on the split between, equity and fixed income. I think the 6040 is pretty ingrained in our society, but theoretically it should be based upon, you know, volatility and all of that sort of thing. But actually, one fly in the ornament on the 6040 proposition is that, as we've seen particularly in the last decade that equities and treasury bonds have had a wonderful negative correlation. Put differently, you hedge equity risk with credit risk-free duration risk, and Ridgewater built its whole business model on that proposition of risk parity. And risk parity models don't work all that very well when you have nowhere to go for the price of the treasury bond. So by definition,

treasuries will be less of a quote unquote hedge to equity risk going forward. And I think that's hugely important for my profession of investment management is recognizing that just as a result of arithmetic, that government duration, long government duration is less useful as a hedge against equity risk going forward. So I think that's where a lot of PhD dissertation should be written going forward. And it has profound implications for risk parity business models. But away from that issue, I think it's just the rate of return

on ownership claims, otherwise known as assets, going forward. because I would like to believe, and I fully believe the Fed would like this outcome, is that inflation goes up from here over the next five to ten years. And inflation going up would be a delightful thing for democracy, because that means that labor is gaining bargaining power, our pricing power versus capital. So therefore, I will applaud all day long as a citizen. But it will also tend to be a inflationary tailwind,

not a disinflationary tailwind. And actually, I'm saying that in a very positive sort of thing, not a negative thing, like you hear frequently, oh, this is going to lead to inflation. I pray it leads to inflation. If it does not lead to inflation, then it is failed. And that over the next five to 10 years, if we shift more power to the people, if you will, you don't do that so much directly as you do that through the democratic process

and you get higher inflation, then it means that valuation should come down for financial assets. or if you want a bumper sticker for it is that the environment, the pro-democracy environment that I envision in the generation ahead is bearish, not bullish for PE multiples. The last 40 years have been a bull market in valuation. And going forward, I think that Wall Street, in the investment management business and the wealthy need to recognize there's such a thing as a bare market in valuation, which would be a secular decline in P multiples, a bare market in bonds, a increase in cap rates for real estate and so forth. So I think for the investment world,

there needs to be a embrace of the notion that the 40-year valuation expansion epic is over. Don't necessarily mean in the next few months. I'm talking about long-term secular trends here. There's one more topic that we really need to ask you about. And I think Joe mentioned in the intro that you coined the term Minsky moment. You also coined the term shadow banking. with Zoltan Poser, who's been on our podcast a couple times now. How do you think shadow banks contributed or what role did they play in the recent market turmoil that we've seen this year?

I think shadow banks morphed after the financial crisis, obviously. the biggest shadow banks became real banks after Lehman went down and the impulse to create a shadow bank shifted to other spaces. But shadow banking is very much alive and will always be with us because it's too tempting. Essentially, a shadow bank is nothing more than using a traditional banking. model, which is inherently profitable, and doing it without government constraints. So it will always be with us. The notion of eliminating shadow banking is nonsensical, and I think it should be nonsensical, because shadow banking is basically an arbitrage around traditional banking, which is a joint

venture between the public and private sector. and shadow banking is simply saying, let's take the public sector out of the banking model and make it a private one, except when we blow up and then we'd like the public sector back. I think shadow banking will be with us for a long period of time, and it should be with us for a long period of time. It's just endemic to capitalism that you always want to arbitrage government rules. In the most recent episode, I think that shadow banks and here I'm just I can use effectively call it the non-bank sector probably exacerbated the malfunctioning of the financial markets and remember chair pal has pounded at the table

that a lot of what they've been doing is to restore and support market functioning and market functioning and market functioning requires market makers. And after the financial crisis, essentially government, democracy, dramatically limited the ability of Wall Street market makers to act like hedge funds. Because that's essentially what they were doing. Lehman Brothers would be a perfect example with leverage. half the distance to the moon. So the depth of Wall Street's ability to absorb risk on part of the system was regulated out of existence. Not out of existence. It was diluted dramatically.

So therefore, when you get a shock, then non-market makers effectively can lock up the markets very, very quickly. And therefore, you have to have the Fed come. and effectively be the market maker of last resort, which is what they've been doing, obviously. So I'm not sure I would so much say that, you know, shadow banks are a culprit or anything of that nature, but they were truly major players and basically saying, we've gotten hit with a shock that induces radical uncertainty,

and we need to offload risk. And in the post-Dod Frank world, whilst the traditional banking sector simply doesn't have the capacity to be the shock absorber in the system, that it ultimately has to be the sovereign as manifest in the central bank itself. Paul McCulley, that was a great conversation, and thank you so much for coming on Adelette. Absolutely, my pleasure. Thank you, Tracy and Joe. Thank you. That was great. Thank you, Paul. That was great. Tracy, I feel like we've hit on a lot of these themes that we touched on with Paul in several of our recent episodes really throughout this crisis. But I don't think anyone has really put all the pieces together as well as Paul can in terms of really politics, macro policy, fiscal handoff, and then also like just what it means for investing.

Yeah. Paul is really able to bring all those sort of different things. strands together in one big narrative. And I think there's a tendency on the part of investors and the market to sort of dismiss concerns about inequality as not really relevant to investing. But I think Paul made a really good point that if you think that the deflation that has basically caused risk assets to go up or contributed to risk assets going up for the past 40 years, all of that is because of that handoff or that dominance of capital versus labor, then the inequality question becomes really, really important for anyone investing. It's not just a topic of, you know, social dynamics and justice and things like that. Yeah, I think the way, like,

I think about it is like maybe people think that fixing inequality is like a technical fix. That it's like, okay, we have this like robust economy, booming market. Oh, but we need to do something about inequality too, as if it's just like this little piece of it, rather than seeing how widening inequality, as Paul puts it, is actually at the heart of this incredible economic and market model that we've had. And it's sort of like, you know, kind of playing people maybe think of this game as Djanga, let's move this little piece, but we can keep the whole thing up, but it's really sort of integral to how it all works and how or the causes of it. It's really deeply connected. Yeah, I think that's absolutely right. And the other thing I will say is that even though we

talk a lot about the handoff from monetary policy to fiscal policy or the mixing of the two, and we're starting to see some change on that front, even though that's happening and, you know, Paul thinks that that could be the thing that sort of brings capital and labor back into balance or, you know, democracy back into play. So far, all of the measures unleashed. by the Federal Reserve have had the effect of increasing inequality as far as I can see, like both for individuals and for capital markets as well, where, you know, big companies can access this booming bond market and smaller firms are still locked out because they can't get loans from, you know, run-of-the-mill banks.

Look, today we're recording this August 20th. It's now been weeks since the unemployment insurance expansion elapsed. And there is not obviously a lot of political appetite. right now. Now maybe by the time people are listening to it, they'll have something. But we, everyone's like talking, including politics, okay, this is the handoff, this is the moment. And if we see, we're at the middle of a crisis, 10% unemployment and we still can't get unemployment insurance expansion. So for as obvious it is as it is to some people that there's a handoff, the reality in D.C. is we're a long way in practice from actually having a

sustained robust fiscal framework that's outside of just a few months in the worst part of the crisis. We're clearly not there yet. Yeah, I think that's right. But it also does make you think what happens when we do finally get like actual substantial fiscal stimulus in some form or another. I also just think in general, and this is a point that you've made a bunch of times, both on podcasts and on Twitter. It's like, and it's what you said before about inequality, but it's like this is all downstream from politics. Like the idea of separating political fights from economic management or whatever, or the idea that we can have a handoff from monetary to fiscal policy, but in a way that's somehow like apolitical, it's unrealistic. Like the fight has to be,

and it's happening, of course, but the fight is first and foremost in politics and then the change in policies if we were to get one comes after that. Yeah. The problem is and always has been politics. And I'm not sure, you know, formally recognizing that does much to change the situation. Maybe it's a start, but I think I'm just very cynical about politics in general. I think you're well justified. Okay. Shall we leave it there? Let's leave it there. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can

follow me on Twitter at Tracy Allo Way. And I'm Joe Wisenthaw. You can follow me on Twitter at the stalwart. Follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. follow the Bloomberg head of podcast Francesca Levy at Francesca Today and check out all of our podcasts under the handle at podcasts. Thanks for listening. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris.

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