Your Global Investment Authority

Investment Outlook
January 2013
Bill Gross
Money for Nothin
Writing Checks for Free
It was Milton Friedman, not
Ben Bernanke, who frst
made reference to dropping
money from helicopters in
order to prevent defation.
Bernankes now famous
helicopter speech in 2002,
however, was no less
enthusiastically supportive
of the concept. In it, he boldly previewed the almost
unimaginable policy solutions that would follow the black
swan fnancial meltdown in 2008: policy rates at zero for an
extended period of time; expanding the menu of assets that
the Fed buys beyond Treasuries; and of course quantitative
easing purchases of an almost unlimited amount should
they be needed. Tese werent Bernanke innovations nor
was the term QE. Many of them had been applied by policy
authorities in the late 1930s and 40s as well as Japan in
recent years. Yet the then Fed Governors rather blatant
support of monetary policy to come should have been a
signal to investors that he would be willing to pilot a
helicopter should the takeof be necessary. Like gold, he
said, U.S. dollars have value only to the extent that they are
strictly limited in supply. But the U.S. government has a
technology, called a printing press (or, today, its electronic
equivalent), that allows it to produce as many U.S. dollars
as it wishes at essentially no cost.
2 JANUARY 2013 | INVESTMENT OUTLOOK
Mr. Bernanke never provided additional clarity as to what he
meant by no cost. Perhaps he was referring to zero-bound
interest rates, although at the time in 2002, 10-year
Treasuries were at 4%. Or perhaps he knew something that
American citizens, their political representatives, and almost
all investors still dont know: that quantitative easing the
purchase of Treasury and Agency mortgage obligations from
the private sector IS essentially costless in a number of
ways. That might strike almost all of us as rather incredible
writing checks for free but that in effect is what a central
bank does. Yet if ordinary citizens and corporations cant
overdraft their accounts without criminal liability, how can the
Fed or the European Central Bank or any central bank get
away with printing electronic money and distributing it via
helicopter yovers in the trillions and trillions of dollars?
Well, the answer is sort of complicated but then its sort of
simple: They just make it up. When the Fed now writes $85
billion of checks to buy Treasuries and mortgages every month,
they really have nothing in the bank to back them.
Supposedly they own a few billion dollars of gold certicates
that represent a fairy-tale claim on Ft. Knoxs secret stash, but
theres essentially nothing there but trust. When a primary
dealer such as J.P. Morgan or Bank of America sells its Treasuries
to the Fed, it gets a credit in its account with the Fed, known
as reserves. It can spend those reserves for something else,
but then another bank gets a credit for its reserves and so on
and so on. The Fed has told its member banks Trust me, we
will always honor your reserves, and so the banks do, and
corporations and ordinary citizens trust the banks, and the
beat goes on, as Sonny and Cher sang. $54 trillion of credit in
the U.S. nancial system based upon trusting a central bank
with nothing in the vault to back it up. Amazing!
But the story doesnt end here. What I have just described is a
rather routine textbook explanation of how central and
fractional reserve banking works its productive yet potentially
destructive magic. What Governor Bernanke may have
been referring to with his essentially free comment
was the fact that the Fed and other central banks such as
the Bank of England (BOE) actually rebate the interest
they earn on the Treasuries and Gilts that they buy. They
give the interest back to the government, and in so
doing, the Treasury issues debt for free. Theoretically its the
prots of the Fed that are returned to the Treasury, but the
prots are the interest on the $2.5 trillion worth of Treasuries
and mortgages that they have purchased from the market. The
current annual remit amounts to nearly $100 billion, an amount
that permits the Treasury to reduce its decit by a like amount.
When the Fed buys $1 trillion worth of Treasuries and
mortgages annually, as it is now doing, it effectively is
nancing 80% of the decit for free.
The BOE and other central banks work in a similar fashion.
British Chancellor of the Exchequer (equivalent to our
Treasury Secretary) George Osborne wrote a letter to Mervyn
King, Governor of the BOE (equivalent to our Fed Chairman)
in November. Transferring the net income from the APF
[Asset Purchase Facility Britains QE] will allow the
Government to manage its cash more efciently, and should
lead to debt interest savings to central government in the
short-term. Savings indeed! The Exchequer issues gilts, the
BOEs QE program buys them and then remits the interest
back to the Exchequer. As shown in Chart 1, the worlds six
largest central banks have collectively issued six trillion dollars
worth of checks since the beginning of 2009 in order to stem
private sector delevering. Treasury credit is being backed with
central bank credit with the interest then remitted to its
issuer. Should interest rates rise and losses accrue to the Feds
portfolio, they record it as an accounting liability owed to the
Treasury, which need never be paid back. This is about as
good as it can get folks. Money for nothing. Debt for free.
INVESTMENT OUTLOOK | JANUARY 2013 3
MONEY FOR NOTHIN
Chart 1
T
r
i
l
l
i
o
n
s

o
f

d
o
l
l
a
r
s
Source: Bianco Research, LLC
May 06, 4.99
Feb 09, 8.95
4
5
6
7
8
9
10
11
12
13
14
15
May
06
May
07
May
08
May
09
May
10
May
11
May
12
Jun 12, 14.09
The Biggest Six Central Bank Balance Sheets
(U.S., U.K, ECB, Japan, China, and Switzerland)
Investors and ordinary citizens might wonder then, why
the fuss over the scal cliff and the increasing amount
of debt/GDP that current decits portend? Why the
austerity push in the U.K., and why the possibly
exaggerated concern by U.S. Republicans over spending
and entitlements? If a country can issue debt, have
its central bank buy it, and then return the interest,
whats to worry? Alfred E. Neuman for President
(or House Speaker!).
Well ultimately government nancing schemes such as
todays QEs or Englands early 1700s South Sea Bubble
end badly. At the time Sir Isaac Newton was asked about the
apparent success of the governments plan and he responded
by saying that I can calculate the movement of the stars but
not the madness of men. The madness he referred to was
the rather blatant acceptance by government and its citizen
investors, that they had discovered the key to perpetual
prosperity: essentially costless debt nancing. The plans
originator, Scotsman John Law, could not have conceived of
helicopters like Ben Bernanke did 300 years later, but the
concept was the same: writing checks for free.
Yet the common sense of John Law and likewise that of
Ben Bernanke must have known that only air comes for free
and is essentially costless. The future price tag of
printing six trillion dollars worth of checks comes in
the form of ination and devaluation of currencies
either relative to each other, or to commodities in less
limitless supply such as oil or gold. To date, central banks
have been willing to accept that cost nay have even
encouraged it. The Fed is now comfortable with 2.5%
ination for at least 12 years and the Bank of Japan seems
willing to up their targeted objective to something above as
opposed to below ground zero. But in the process, zero-
bound yields and their QE check writing may have distorted
market prices, and in the process the ow as well as the
existing stock of credit. Capital vs. labor; bonds/stocks vs.
cash; lenders vs. borrowers; surplus vs. decit nations;
rich vs. the poor: these are the secular anomalies and
mismatches perpetuated by unlimited check writing
that now threaten future stability.
Ben Bernanke has publically acknowledged these growing
disparities. We are quite aware, he said in November 2011,
that very low interest rates, particularly for a protracted
period, do have costs for a lot of people I think the
response is, though, that there is a greater good here, which
is the health and recovery of the U.S. economy... I mean,
ultimately, if you want to earn money on your investments,
you have to invest in an economy which is growing.
That growth now is to be measured each and every
employment Friday via an unemployment rate thermostat set
at 6.5%. We at PIMCO would not argue with that objective.
Yet we would caution, as Bernanke himself has cautioned, that
there are negative consequences and that when central banks
enter the cave of quantitative easing and essentially costless
electronic printing of money, there may be dragons.
4 JANUARY 2013 | INVESTMENT OUTLOOK
Investment conclusions
Investors should be alert to the longterm inationary thrust of
such check writing. While they are not likely to breathe
re in 2013, the inationary dragons lurk in the out
years towards which long-term bond yields are
measured. You should avoid them and conne your
maturities and bond durations to short/intermediate
targets supported by Fed policies. In addition, be aware of
PIMCOs continued concerns about the increasing
ineffectiveness of quantitative easing with regards to the real
economy. Zero-bound interest rates, QE maneuvering, and
essentially costless check writing destroy nancial business
models and stunt investment decisions which offer
increasingly lower ROIs and ROEs. Purchases of paper
shares as opposed to investments in tangible productive
investment assets become the likely preferred corporate
choice. Those purchases may be initially supportive of stock
prices but ultimately constraining of true wealth creation and
real economic growth. At some future point, risk assets
stocks, corporate and high yield bonds must recognize the
difference. Bernankes dreams of economic revival, which
would then lead to the day that investors can earn higher
returns, may be an unattainable theoretical hope, in contrast
to a future reality. Japan we are not, nor is Euroland or the
U.K. just yet. But costless check writing does indeed have
a cost and checks cannot perpetually be written for free.
William H. Gross
Managing Director
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond
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