Just three recent cases that make the point.
The Costliest Mistake In All Of Economics
Joe Weisenthal | Oct. 16, 2011, 1:37 PM | 6,484
This week saw something stunning: The world’s most famous bond manager, Bill Gross, was forced to send out an apology to investors over his dismal performance this year.
It’s obvious why he had to do it. With equity markets incredibly volatile, people think of their bond investments as their anchor of stability, smoothing out volatility and canceling out losses in any climate. The PIMCO Total Return Fund (PTTAX) has failed to do that, and is actually down over the last year. As such, his fundraising numbers have shriveled.
PTTAX 1-Year Performance
What made his year so bad? Well, as he puts it, he expected a “new normal” (2% growth, 2% inflation) but things have gotten much worse, causing a rush into long-term fixed income instruments which he was betting against.
But going back over his writings over the past year, you can see that his error actually went much deeper.
A key reason he’s shied away from U.S. debt (up until now) is his fear of massive U.S. deficits, and the belief that these deficits would turn investors away from our debt.
His August 2011 letter — which was basically written right at the peak of the chart above — lead off with three bullet points that got right to his thinking at the time
- Nothing in the Congressional compromise reached over the weekend makes a significant dent in our $1.5 trillion deficit.
- In addition to an existing nearly $10 trillion of outstanding Treasury debt, the U.S. has a near unfathomable $66 trillion of future liabilities at “net present cost.”
- Aside from outright default, there are numerous ways a government can reduce its future liabilities. They include balancing the budget, unexpected inflation, currency depreciation and financial repression.
Because he expected “unexpected inflation,” “currency depreciation,” and “financial repression” he was not going to be exposed to U.S. Treasuries. Instead, he wrote:
Based on historical example at Moody’s and Standard & Poors, it just might take 50 years for them to downgrade U.S. credit, but be that as it may, you and PIMCO as savers and savings intermediaries can take precautionary or even retaliatory measures to preserve purchasing power. Favor countries with cleaner “dirty shirts” and higher real interest rates: Canada, Mexico, Brazil and Germany come to mind. Shade equity and fixed income investments away from dollar based indexes towards those of developing nations with stronger growth prospects. Purchase commodity based real assets before reserve surplus nations do.
This was an extremely costly conclusion to make. Fear of deficits, and the belief that higher deficits would be bad for fixed income, clearly cost PIMCO a lot of money.
Other economists saw the blunder in real time.
In June of this year, right before the Total Return Fund started going off the rails, Paul Krugman wrote a brutal post called The Decline Of PIMCO Macro:
For the past year or so, however, Pimco seems to me to have been making less and less sense. Gross bet big on the idea that rates would spike when quantitative easing ends; I guess he has three weeks to be vindicated, but it sure doesn’t look like it. And the economic logic was all wrong. Now Mohamed El-Erian is claiming that inflation in China and Brazil is Bernanke’s fault; again, the economic logic is all wrong.
What’s strange about this is that nobody was better at laying out the logic of deleveraging and its consequences than Pimco’s Paul McCulley. But maybe that’s the explanation: McCulley has moved on.
In fairness to Bill Gross, this fear of deficits extends all the way to the top, and by that we mean the decision makers in Washington DC.
While the economy clearly could use more government stimulus, the dominant talk in Washington is all about where to cut back and how to “get our fiscal house in order.” And because Washington is obsessed with this, we had to go through the wrenching debt ceiling fight, which seems to have clearly dealt a confidence blow at the worst possible time.
In fact, you can go back even further, to Obama’s first days in office, and the original stimulus, and see that fear of deficits and bond vigilantes was one factor in making the original stimulus too small.
So literally every American (not just those in the Total Return Fund) who depends on a robust recovery is hurt by this misplaced fear of deficits.
It’s because the misplaced fear of higher deficits is so costly that Richard Koo of Nomura recently wrote that we should not even be uttering anything about them, even when talking about the long term!
Arguing need for longer-term fiscal consolidation is irresponsible
The insistence that fiscal consolidation is necessary in the longer term is like the doctor who, faced with a patient who has just been admitted to the intensive care ward, repeatedly questions the patient about his ability to afford the treatment. This is both lacking in decency and irresponsible.
If the patient loses heart after learning the cost of the treatment, he may end up spending even longer in the hospital, leading to a larger final bill. Completely ignoring the policy duration effect of fiscal policy and constantly insisting on longer-term fiscal consolidation was what prolonged Japan’s recession.
And really, the costliness of deficit fears is all over the place. Kyle Bass has been betting against the Japanese Yen for awhile now due to Japan’s deficit issues, only to watch the yen race to mult-decade highs.
Unfortunately, no matter how badly the theory (that higher deficits will cause interest rates to shoot up) fails to jibe with reality, the misconception persists. Just two weeks ago, a well-known newspaper’s op-ed page was railing on Bernanke for keeping the bond vigilantes at bay via quantitative easing, wailing that if only the Fed weren’t involved, the market would be forcing some real discpline on Congress via higher rates.
The fact of the matter is that this connection between deficits and rates is patently false.
This is true over the long term, as seen here comparing the US debt to the 10-year rates:
And it’s true over the short term. Here’s a look at deficits and 10-year rates just during the Bush administration.
Until this misconception goes away, we’re almost certainly going to see plenty more policy mistakes, as well as big investors losing their shirts by betting the wrong way.
This is from Paul Krugman’s own blog:
October 16, 2011, 5:50 PM
Somehow I missed this: Joe Weisenthal informs us that Bill Gross has publicly apologized for getting the bond market so wrong, predicting a spike in interest rates when QE2 ended. As Weisenthal points out, however, Gross’s exaggerated fear of deficits was very widespread; it was, indeed, what all the Very Serious People were obsessing about, even as the real economy was falling apart.
Weisenthal also points out that I called this in real time. If you want to have some fun, read the vituperative comments on that post.
The thing is, all it took to get this right was understanding IS-LM, and taking it seriously.
Flashback: Paul Krugman
- October 14, 2011 | 9:42 am
The political constraints on the Obama Administration in January, 2009, were very real. Even if the president had pushed for a much bigger stimulus, it’s unlikely Congress would have passed one, at least as long as the filibuster remained in place.
Still, this excerpt from a Paul Krugman column is downright eerie:
This really does look like a plan that falls well short of what advocates of strong stimulus were hoping for — and it seems as if that was done in order to win Republican votes. Yet even if the plan gets the hoped-for 80 votes in the Senate, which seems doubtful, responsibility for the plan’s perceived failure, if it’s spun that way, will be placed on Democrats.
I see the following scenario: a weak stimulus plan, perhaps even weaker than what we’re talking about now, is crafted to win those extra GOP votes. The plan limits the rise in unemployment, but things are still pretty bad, with the rate peaking at something like 9 percent and coming down only slowly. And then Mitch McConnell says “See, government spending doesn’t work.”
Yup. The only thing Krugman got wrong was the unemployment rate. It peaked even higher, topping 10 percent. (See above.)
This is from Paul Krugman’s blog again:
October 13, 2011, 8:43 AM
Mike Konczal has some thoughts on the Obama administration’s economic missteps, and mentions that there were reports in Fall 2009 that the administration was afraid of the invisible bond vigilantes:
Noam Schieber at the New Republic was getting word from Treasury as early as late 2009 that they thought that they needed “some signal to U.S. bondholders that it takes the deficit seriously” and “spending more money now [on stimulus] could actually raise long-term rates, thereby offsetting its stimulative effect.” This naturally lead to wanting to strike “grand bargains” with the other side, a path that lead the administration down some bad roads in terms of the agenda.
I was hearing the same thing, with more specifics; as I wrote at the time,
Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade; this could, they believe, drive rates way up, even though this possibility doesn’t seem to be priced in by the market.
Even then, this seemed awesomely wrong-headed: policy makers were being scared off dealing with a real economic disaster by threats that existed only in their imagination. Now, of course, it looks even worse.
October 11, 2011, 6:39 PM
Sorry, but if I am not for myself, who will be for me? For readers new to this, back in 2010 Business Week ran a story contrasting my pessimistic views with the bullish outlook of hedgie John Paulson, and making it clear that only a fool would believe the views of some bearded professor.
Today in the FT: Paulson’s costly bet on US rebound unravels.
It’s also worth noting not just that things have in fact gone badly, but the way they’ve gone badly: not via surging interest rates and inflation, but via weak demand associated with low rates, and with markets now expecting very low inflation looking forward.
The point isn’t that I’m infallible, which (as my wife can tell you) is very far from true. It is that Keynesian analysis has worked in this crisis, and those who refused to believe it have lost money as well as credibility.