Ed Note: Always worth reading, the highly regarded Bill Gross runs the Massive 1/4 Trillion Dollar Bond Pimco Bond Fund

Bill Gross Warns Of Financial Market Implosion And The End Of Economic Life As We Know It

The Key Point according to the Financial Times:

“Conceptually, when the financial system can no longer find outlets for the credit it creates, then it de-levers.”

As Gross Explains (Emphasis via the Financial Times)

But before ringing in the New Year with a rather grim foreboding, let me at least describe what financial markets came to know as the “old normal.” It actually began with early 20th century fractional reserve banking, but came into its adulthood in 1971 when the U.S. and the world departed from gold to a debt-based credit foundation. Some called it a dollar standard but it was really a credit standard based on dollars and unlike gold with its scarcity and hard money character, the new credit-based standard had no anchor – dollar or otherwise. All developed economies from 1971 and beyond learned to use credit and the expansion of debt to drive growth and prosperity.

Almost all developed and some emerging economies became hooked on credit as a substitution for investment in tangible real things – plant, equipment and an educated labor force. They made paper, not things, so much of it it seems, that they debased it. Interest rates were lowered and assets securitized to the point where they could go no further and in the aftermath of Lehman 2008 markets substituted sovereign for private credit until it appears that that trend can go no further either. Now we are left with zero-bound yields and creditors that trust no one and very few countries. The financial markets are slowly imploding – delevering – because there’s too much paper and too little trust. Goodbye “Old Normal,” standby to redefine “New Normal,” and welcome to 2012’s “paranormal.”

Thus we enter the ‘great deleveraging’ — brought on by preferences focused on real or liquid assets which constrain money supply and eat away at our 40-year global credit expansion like ‘invisible termites’.

At this point capital preservation becomes the investor’s mantra, not the idea of additional return:

Will Rogers once fondly said in the Depression that he was more concerned about the return of his money than the return on his money. But from a system-wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may breakdown. We all start to resemble Will Rogers.

Whether it’s via deflation or inflation, time depreciation of money (or wealth) is now guaranteed.

As Gross sees it, both eventualities are equally possible:

This new duality – credit and zero-bound interest rate risk – is what characterizes our financial markets of 2012. It offers the fat-left-tailed possibility of unforeseen – delevering – or the fat-right-tailed possibility of central bank inflationary expansion.

Only the actions of governments and central banks can determine which way the wealth destruction will happen. Deflation would reward the holders of ‘non-productive’ government debt, while inflation would reward the holders of tangible real assets. QE (or a lack of QE), meanwhile, could help tip the balance either way.

What’s fair to say is that without government intervention continued capital flows into “safe government securities” would lead to an inevitable giant tidal wave of deflation — just as they did during the original Great Depression.