Whip Deflation Now, says McCulley

The folks at Pimco have been right on the money with their crystal ball, and performance, of late. Their take on the crisis has been the polar opposite of the financial blogosphere, which is long on finger pointing but short on pragmatism.

The bears are getting steamrolled today; their favorite whipping boy has been the XLF ETF, which is barely down year-to-date. Perhaps they can take a page from Kate Welling, the former editor of Barron's who now writes for Weeden & Co.:

Don’t mess around with this Minsky moment is the straight- forward message of PIMCO’s normally optimistic economist, Paul McCulley.

Step 1 is to recognize the fix we’ve borrowed ourselves into, a debt deflationary spiral, anchored by depreciating property prices on the backside of triple bubbles in housing, mortgage finance and the shadow banking system and complicated by the soaring weak-dollar-denominated prices of food and energy.

Step 2 is to pull out the monetary and fiscal stops to arrest this vicious self-feeding cycle. There aren’t any good options, just less-bad choices. Now is not the time for finger-pointing or moralizing. Digging out of this mess will require even more sizeable and focused policy responses than we’ve seen in recent weeks—and lots of time. There will be plenty of shared sacrifice to go around. Blame can be apportioned and the rules revised...later. . Kate Welling

Time will if tell Bernanke is a genius, although some people would rather die than ever have to admit it. But McCulley did tip his hat to Bernanke on the day the TSLF was announced:

The Fed played a hugely important card while we will never know the counterfactual, it was clearly a bold, aggressive, appropriate step. My hat is off to them. They are putting up to $200 billion of Treasuries that the Street desperately wants into their hands and taking off of their hands $200 billion of what they have difficulty financing. Now, the Fed is not taking the risk of the mortgages, just providing financing on the mortgages, where the private sector doesn’t want to do it. But they are essentially allowing the broker community to finance their mortgages at the same rate as Treasuries.

McCulley is well aware that the taxpayer is the ultimate bag-holder here in the (non) bail-outs.. But a warrant in the upside, ala Chrysler or the RTC, might prove a palatable option to the angry mob:

The precedent for that would be the Chrysler bailout. Uncle Sam backed Chrysler’s paper, but got warrants in Chrysler and eventually made money.

McCulley is not a perma-Armageddonist. But our imperfect model of capitalism has its moments:

We have an amazing ability to make colossal mistakes, but we do tend to recognize them and get on with trying to fix them, through some combination of the invisible hand of the market and the visible fist of the government, so we can get on with life. It’s what Alan Greenspan calls, “The remarkable flexibility of our economy.” We have a huge asset in the recuperative powers of our economy. What we’ve got going on right now in the debt deflation and property deflation is probably the most nefarious problem we’ve had in 25 years or more. (You have to go back to the late 1970s, when it looked like we were no longer controlling our own destiny, to find a period, in my view, that was as bleak.) But we do have the will and the means to get on with life. America is very much a going concern.

Good times? No Not Good Times. But getting better, with any luck.

Something the bears will eventually have to ponder, even if they won’t admit it. Although I have to admit, that run in the XLF might soon be out of steam.

Paul McCulley, required reading.

Not Good Times
Pimco Global Central Bank Focus

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