J. Bradford DeLong's Blog, page 1142
October 2, 2014
Afternoon Must-Read: Financial Times: ECB’s Mario Draghi and His Misguided Malcontents
Financial Times: ECB’s Mario Draghi and his misguided malcontents: "Two years ago, Mario Draghi pledged to do 'whatever it takes' to save the euro...
...to use the full monetary policy arsenal to revive the stalling eurozone economy. On Thursday, the European Central Bank president primed his latest weapon.... Yet misguided opposition from inside and outside the bank continues to prevent him firing at will. His colleagues should pass him the ammunition and move out of his way.... The feeble eurozone recovery has stalled. The inflation rate in the currency area is down to 0.3 per cent and the core economies of Germany, France and Italy are at or close to standstill.... Mr Schäuble is not wrong to emphasise the need for structural reform within eurozone economies, but liberalisation and asset purchases are complements.... Reality must at some point impinge upon the monetary theocrats: the threat of outright deflation in the eurozone is not a sign of rising competitiveness--it is a menace.... Since the onset of the eurozone sovereign debt crisis in 2010, the standard pattern has been to do the right thing between six and 18 months too late, the delay generally originating in Frankfurt or Berlin. Now is another opportunity to ditch faulty analysis and wrong-headed policy and arrest deflation before it takes hold. Mr Draghi has shown the right instincts since he took over the ECB presidency. Those critics who have been proved wrong again and again in the eurozone crisis should stop standing in his path.
Inflation Hawks Unrepentant and Zombified Watch!: (Early) Friday Focus for October 3, 2014
Over at Equitable Growth: My bet with Noah Smith:
"IF at any time between 7/28/2012 and 7/28/2015 core consumer prices...
...as recorded in the FRED database series CPILFESL, are up more than 5% in the preceding 12 months, and if over the same 1-year period monthly U3 unemployment (as recorded in FRED database series UNRATE) has not averaged below 6%:
THEN Brad DeLong agrees to buy Noah Smith one dinner at Zachary's Pizza at 1853 Solano Ave. in Berkeley CA, and to pay Noah 49 times the cost--including tax but excluding tip--of Noah's meal at Zachary's in Federal Reserve notes, or in alternative means of payment accepted by Zachary's should Zachary's Pizza no longer be accepting Federal Reserve notes at the date of the dinner.
This cost will be assessed as the total cost of the dinner to all, divided by the number of people present, regardless of how much pizza is consumed by or how much alcohol is drunk by specific individuals. If however, the above condition is not satisfied, Noah agrees to buy Brad one dinner at Zachary's.
Miles Kimball will be the judge in charge of refereeing the bet. The decisions of the judge will be final and unappealable.
Furthermore, Noah's brave and gracious willingness to take the John Cochrane-Argentina side of this bet at odds of only 50-1 will not be construed as a statement of his confidence in or of his support for any economist or position of economic analysis that judges expansionary fiscal policy at the zero lower nominal interest rate bound to be "insane", or that judges "1932" to currently be a less dire risk for the U.S. than "Argentina".
In retrospect, given Bernanke's unwillingness to split the FOMC over policy, it was grossly unfair of me to give Noah only 50-1 odds:
We now have only ten more data points to see before the bet expires, and the last two data points are now in the average that must be over 5.0%/year for Noah to win. Annualized, the two data points we have are: July: 1.2%/year; August: 0.9%/year. The ten remaining data points must thus average more than 5.8%/year for Noah to win his bet.
And, as I said before, the question remains of what wine we should brown-bag to Zachary's: I am partial to a Chateau Mouton myself, but perhaps better values are had in Haut Medocs or in Francis Ford Coppola's Archimedes, and we could always invite Paul Ryan to come to learn some real economics and drink an Échezeaux, if we felt like following the taste of the House of Valois-Burgogne rather than the House of Plantagenet, and going for wines descended from the Burgundy served to Duchesse Marie la Riche rather than from the Bordeaux served to King Edward IV...
But perhaps the most interesting thing I learn today about my bet with Noah is this: A bunch of the people whose astonishing unwisdom originally provoked it are not marking their beliefs to market and hedging, but rather doubling down:
Caleb Melby, Laura Marcinek and Danielle Burger: Fed Critics Say ’10 Letter Warning Inflation Still Right: "Signatories of a letter sent to then-Federal Reserve Chairman Ben S. Bernanke in 2010...
...are standing by their claims... that the Federal Reserve... risked “currency debasement and inflation”... “distort[ed] financial markets”....
Jim Grant....
I think there’s plenty of inflation--not at the checkout counter, necessarily, but on Wall Street... at the expense of other things, including the people who saved all their lives and are now earning nothing on their savings....
John Taylor...
inflation, [un]employment... destroy[ed] financial markets, complicate[d]... normaliz[ation]... all have happened....
Douglas Holtz-Eakin....
The clever thing... is never give a number and a date. They are going to generate an uptick in core inflation.... I don’t know when, but they will.
Niall Ferguson... saying his thoughts haven’t changed....
This bull market has been accompanied by significant financial market distortions, just as we foresaw. Note that word ‘risk.’ And note the absence of a date. There is in fact still a risk of currency debasement and inflation.
David Malpass....
The letter was correct”....
Amity Shlaes....
Inflation could come... the nation is not prepared....
Peter Wallison...
All of us... have never seen anything like what’s happened here. This recovery... by far the slowest... in the last 50 years.
Geoffrey Wood...
Everything has panned out.... If the Fed doesn’t ease money growth into it, inflation could arrive.
Richard Bove...
Someone’s got to prove to me that inflation did not increase in the areas where the Fed put the money....
Cliff Asness... declined to comment. Michael Boskin... didn’t immediately respond.... Charles Calomiris... was traveling and unavailable.... Jim Chanos... didn’t return a phone call or an e-mail.... John Cogan... didn’t respond.... Nicole Gelinas... didn’t respond.... Phone calls... and an e-mail... to Kevin A. Hassett... weren’t returned. Roger Hertog... declined to comment.... Gregory Hess... didn’t immediately return.... Diana DeSocio... said Klarman stands by the position.... William Kristol... didn’t immediately return a call.... Ronald McKinnon... died yesterday prior to a Bloomberg call.... Dan Senor... didn’t respond.... Stephen Spruiell... declined to comment...
I am sorry that I will never learn what Ron McKinnon would have said--the last time I talked to him, at the San Francisco Fed, he said he was working on some ideas about why and where the enormous money-printing by the Fed had been soaked up.
And I do not know which is worse and less professional:
Asness, Boskin, Calomiris, Chanos, Cogan, Gelinas, Hassett, Hertog, Hess, Klarman, Kristol, and Spruiell; who stand mute.
Grant, Taylor, Ferguson, Malpass, and Wood, and Bove; who claim that the letter's warnings were prescient: "The letter mentioned several things... inflation, employment... destroy financial markets, complicate the Fed’s effort to normalize... and all have happened..."
Holtz-Eakin, Shlaes, and Ferguson (again); who claim it was always the "there are risks!" con: “The clever thing forecasters do is never give a number and a date. They are going to generate an uptick in core inflation. They are going to go above 2 percent. I don’t know when, but they will.”
The only one who emerges from this with any credit at all is Peter Wallison:
Wallison: “All of us, I think, who signed the letter have never seen anything like what’s happened here. This recovery we’ve had since the end of 2009 has been by far the slowest we’ve had in the last 50 years...”
But even he gives no further reflections on why the clear and present economic dangers and imminent economic threats he saw back then have shown no signs at all of any existence.
My take: Mark your beliefs to market, people! Learn from history, people! As George Santayana said: "Those who do not remember the past are condemned to repeat it." You can argue that that is a form of justice for you. But it is not a form of justice for us--because your amnesia dooms us to repeat the bad parts of it with you sometime in the future.
Noted for Your Morning Procrastination for October 2, 2014
Over at Equitable Growth--The Equitablog
Morning Must-Read: Alice Chen et al.: Why Is Infant Mortality Higher in the US than in Europe? - Washington Center for Equitable Growth
Morning Must-Read: Paul Krugman: Ordoarithmetic - Washington Center for Equitable Growth
Why I Am Coming to Think It Is Time to Dismantle the Eurozone and Restore North Atlantic Economic Policy Hegemony to Washington: Thursday Focus for October 2, 2014 - Washington Center for Equitable Growth
PIMCO: How to Lose (Lots of) Money and Still Influence People: The Honest Broker for the Week of October 10, 2014 - Washington Center for Equitable Growth
Two on Bloomberg TV: Ebola, and Robotization and Real Wages - Washington Center for Equitable Growth
Morning Must Read: Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers on the Treasury Under Geithner and Lew Offsetting the Stimulative Effects of Federal Reserve Quantitative Easing - Washington Center for Equitable Growth
Ebola Virus Talking Points: Wednesday Focus for October 1, 2014 - Washington Center for Equitable Growth
Talking Points: Robots, Wages, Technology, Peter Thiel - Washington Center for Equitable Growth
Afternoon Must-Read: Paul Krugman: The Pimco Perplex - Washington Center for Equitable Growth
Plus:
Things to Read on the Morning of October 2, 2014 - Washington Center for Equitable Growth
Must- and Shall-Reads:
Mark Zandi: Job creation key to economic comeback
Paul Krugman: The Pimco Perplex: "Why was Gross betting so heavily against Treasuries? Brad DeLong tries to rationalize Gross’s behavior in terms of a coherent story about an impending U.S. recovery, which would lift us out of the liquidity trap. But Gross wasn’t saying anything like that. Instead, he was claiming that the Fed’s asset purchases--QE2--were holding rates down, and warned that the impending spike in rates when QE2 ended would derail recovery. So why did he believe all that? It all comes down, I’d argue, to liquidity trap denial. Since 2008 the basic logic of the economic situation has been that the private sector is trying to run a huge surplus, and the public sector isn’t willing to run a corresponding deficit.... A lot of people--politicians, of course, but also a lot of people in finance--have just refused to accept this account.... You might think the failure of higher rates to materialize, year after year, would cause them to reassess.... Instead, however, many of them made excuses. Above all, the big excuse was that rates would have gone higher if only the Fed weren’t buying up the stuff.... You can see why I found Gillian Tett’s apologia for Gross--that he was blindsided by central bank intervention--frustrating. For one thing, that’s accepting a model that has failed with flying colors; but beyond that, Gross’s really bad call was almost exactly the opposite, his claim that rates would soar when the Fed’s intervention ended.... Finance people seem weirdly determined to believe in a macro canon whose hold on their perceptions appears to be completely unbreakable, no matter how much money it causes them to lose."
Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers: Government Debt Management at the Zero Lower Bound: "Responding, Larry Summers said, in Binyamin Applebaum's summary, that "his opponents... [were] 'central bank independence freaks' and... [that] it was 'at the edge of absurd' to suggest that debt management coordination would substantially erode the Fed’s independence."
Paul Krugman: Ordoarithmetic: "Francesco Saraceno is furious and dismayed at Hans-Werner Sinn, who says among other things that deflation in southern Europe is necessary to restore competitiveness. Why not inflation in Germany, he asks? But Saraceno fails to understand German logic here. As they see it, their economy was in the doldrums at the end of the 1990s; they then cut labor costs, gaining a huge competitive advantage, and began running gigantic trade surpluses. So their recipe for global recovery is for everyone to deflate, gaining a huge competitive advantage, and begin running gigantic trade surpluses. You may think there’s some kind of arithmetic problem here, but in Germany they have their own intellectual tradition."
Alice Chen et al.: Why is Infant Mortality Higher in the US than in Europe?: "The US has a substantial – and poorly understood – infant mortality disadvantage relative to peer countries. We combine comprehensive micro-data on births and infant deaths in the US from 2000 to 2005 with comparable data from Austria and Finland to investigate this disadvantage. Differential reporting of births near the threshold of viability can explain up to 40% of the US infant mortality disadvantage. Worse conditions at birth account for 75% of the remaining gap relative to Finland, but only 30% relative to Austria. Most striking, the US has similar neonatal mortality but a substantial disadvantage in postneonatal mortality. This postneonatal mortality disadvantage is driven almost exclusively by excess inequality in the US: infants born to white, college-educated, married US mothers have similar mortality to advantaged women in Europe. Our results suggest that high mortality in less advantaged groups in the postneonatal period is an important contributor to the US infant mortality disadvantage."
Dan Davies: Bedtime for market efficiency: "People have been calling on the economics profession to make some fairly serious revisions to the way the subject is taught.... I think there’s one thing that really can’t be denied: when this particular phoenix rises from the flames, it ought to leave the Efficient Markets Hypothesis back in the ash pit.... Efficient markets gets a chapter of its own in John Quiggin’s Zombie Economics as an idea that won’t go away, no matter how thoroughly it’s refuted.... The temptation will be to try and avoid going “cold turkey” on efficient markets, by reducing the overarching claims, but hanging on to the general story that markets are 'broadly efficient'.... The hypothesis that there is no information in the past history of share prices which can be used to predict the future... doesn’t work.... Companies like AQR have been offering funds based on them, and generally outperforming, for ages. And when you get to anything stronger than the very-weak form versions, the performance is really quite embarrassing. Robert Shiller’s share of the Nobel Prize was for noticing that securities prices are, in general, much too volatile to make sense as forecasts.... DeLong, Summers, Shleifer & Waldmann have shown that there is no real theoretical basis to the idea that 'traders competing against each other make markets efficient'--it’s just as likely that they create meaningless volatility. Market prices are... a weighted average of the views of a large group of well-resourced and intelligent people with an incentive to get things right. But nobody would build a theory of politics around the infallibility of opinion polls.... All that’s really left of market efficiency is a sort of woolly idea that 'it’s difficult to make money in the stock market'. Which it is, but it’s pretty difficult to make money in any other way too, a fact which has fewer implications for fundamental economic truth than you’d think..."
And Over Here:
Liveblogging the American Revolution: October 2, 1776: Washington's Paralysis (Brad DeLong's Grasping Reality...)
The Kansas Conservative Con: Live from the Roasterie (Brad DeLong's Grasping Reality...)
Over at Equitable Growth: Why I Am Coming to Think It Is Time to Dismantle the Eurozone and Restore North Atlantic Economic Policy Hegemony to Washington: Thursday Focus for October 2, 2014 (Brad DeLong's Grasping Reality...)
Hoisted from the Archives: New Preface to Charles Kindleberger: "The World in Depression" (Brad DeLong's Grasping Reality...)
PIMCO: How to Lose (Lots of) Money and Still Influence People: The Honest Broker for the Week of October 10, 2014 (Brad DeLong's Grasping Reality...)
A Public-Service Announcement: Twitter Is Dangerous...: Live from Crows Coffee (Brad DeLong's Grasping Reality...)
Liveblogging World War I: October 1, 2014: The Battle of Arras (Brad DeLong's Grasping Reality...)
Over at Equitable Growth: Ebola Virus Talking Points: Wednesday Focus for October 1, 2014 (Brad DeLong's Grasping Reality...)
Should Be Aware of:
Justin Fox: Understanding China's Hard Line on Hong Kong
Carl Zimmer: The Evolution of Sleep: 700 Million Years of Melatonin: "When the sun sets, the encroaching darkness sets off a chain of molecular events spreading from our eyes to our pineal gland, which oozes a hormone called melatonin into the brain. When the melatonin latches onto neurons, it alters their electrical rhythm, nudging the brain into the realm of sleep. At dawn, sunlight snuffs out the melatonin, forcing the brain back to its wakeful pattern again.... Scientists have long wondered how this powerful cycle got its start. A new study on melatonin hints that it evolved some 700 million years ago.... Maria Antonietta Tosches and her colleagues examined how different genes became active in the worm larvae. They discovered that some cells on the top of the larvae make light-catching proteins--the same ones we make in our eyes to switch melatonin production on and off. These same cells also switch on genes required to produce melatonin.... They found that the worms didn’t produce melatonin all the time. Instead, they made it only at night, just as we do.... When it comes to melatonin, humans and worms are so similar that they can both get jet lag..."
David Glasner: Explaining the Hegemony of New Classical Economics: "Instead of pursuing microfoundations as an explanatory strategy, the New Classicals chose to impose it as a methodological prerequisite. A macroeconomic model was inadmissible unless it could be explicitly and formally derived from the optimizing choices of a fully rational agent.... Instead of using microfoundations as a method by which to make macroeconomic models conform more closely to the imperfect and limited informational resources available to actual employers deciding to hire or fire employees, and actual workers deciding to accept or reject employment opportunities, the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption.... Some parts of chemistry have been reduced to physics, which is a good thing, especially when doing so actually enhances our understanding of the chemical process and results in an improved or more exact restatement of the relevant chemical laws. But it would be absurd and preposterous simply to reject, on supposed methodological principle, those parts of chemistry that have not been reduced to physics.... But reductionism is what modern macroeconomics, under the New Classical hegemony, insists on. No exceptions allowed; don’t even ask. Meekly and unreflectively, modern macroeconomics has succumbed to the absurd and arrogant methodological authoritarianism of the New Classical Revolution. What an embarrassment."
Liveblogging the American Revolution: October 2, 1776: Washington's Paralysis
From John Ferling, The Ascent of George Washington:
The Kansas Conservative Con: Live from the Roasterie
It is very clear to me that the Cato Institute's health-care economists Michael Cannon, Jagadeesh Gokhale "Estimating the Effect of the Patient Protection and Affordable Care Act on Kansas Medicaid Expenditures", Should Kansas Expand Medicaid Under the Affordable Care Act? A Perspective On Weighing the Costs and Benefits, and Angela Erickson (Jagadeesh Gokhale and Angela Erickson The Effect of Federal Health Care ‘Reform’ on Kansas General Fund Medicaid Expenditures) did not believe that turning down the Medicaid expansion was in the interest of the people of Kansas. They sold it to the Kansas legislature that way, but what they thought was that if enough states rejected the Medicaid expansion then congressional Democratic support for ObamaCare would collapse and a better deal could then be negotiated at the federal level. It is very clear to me that Arthur Laffer did not believe that Sam Brownback's tax-cut proposals would immediately jump-start Kansas's economy the way he told the Kansas Republican Party that they would.
There was a con.
The question is: who was in on the con? Was it Cannon, Gokhale, Erickson, Laffer, Crane, and company conning Charles Koch? Was it Cannon, Gokhale, Erickson, Laffer, Crane, Koch, and company conning Sam Brownback? Was it Cannon, Gokhale, Erickson, Laffer, Crane, Koch, Brownback, and company conning the Kansas Republican Party? Or was it Cannon, Gokhale, Erickson, Laffer, Crane, Koch, Brownback, the Kansas Republican Party, and company conning the voters of Kansas? I would dearly like to know the inside story...
Dylan Scott: Retired GOP Senator Refused To Film Campaign Ad For Pat Roberts: "Former Sen. Nancy Kassebaum Baker (R-KS) refused to film a campaign TV ad...
...on behalf of vulnerable incumbent Sen. Pat Roberts (R-KS), the Kansas City Star reported Tuesday. Kassebaum Baker represented Kansas in the Senate from 1978 to 1997 and was succeeded by Roberts, who had been a congressman. Her father Alf Landon was governor of Kansas and the Republican nominee against FDR in 1936. “There’s just disappointment around the state,” she told the Star of Roberts. “They feel they don’t know him now.”...
Kassebaum Baker had previously criticized Roberts in a Washington Post profile of Roberts last week. She singled out Roberts' vote in 2012 against a United Nations treaty that would have banned discrimination against people with disabilities. Another former Kansas Republican senator, Bob Dole, who is himself disabled, had advocated for the treaty. “People thought, ‘Gosh, why couldn’t he have done that for Bob?’ ” she said. “That just triggered an emotional disappointment with Pat. I think that carried on and has not been changed.”
John Judis: Sam Brownback's Conservative Utopia in Kansas Has Become Hell: "The midterm elections of 2010 were good for Republicans nearly everywhere...
...but amid the national Tea Party insurgency, it was easy to overlook the revolution that was brewing in Kansas.... [Brownback's] administration, he declared, would be a 'real live experiment' that would prove, once and for all, that the way to achieve prosperity was by eliminating government from economic life.... Republicans cheered him on. 'This is exactly the sort of thing we want to do here, in Washington, but can’t, at least for now', Senate Minority Leader Mitch McConnell told Brownback. Influential conservatives in Washington even started talking about him as a promising presidential candidate for 2016. It did not occur to them that less than two years later, Brownback would be struggling even to win reelection in a reliably red state, his party in disarray and his conservative castle crumbling....
In addition to his sweeping tax cuts, Brownback wanted to eliminate the earned-income tax credit, which had benefited the working poor. He cut about $200 million in the state’s spending on education—the largest such reduction in the state’s history; and he proposed changing the school financing formula at the expense of poorer, urban districts. He sought to centralize power by eliminating an important legacy of the state’s moderate Republicanism: a nonpartisan commission that recommends judicial nominees.... After he had ousted the moderate Republicans, Brownback was able to push an ideologically pure agenda with almost no real opposition.... By June of 2014, the results of Brownback’s economic reforms began to come in, and they weren’t pretty. During the first fiscal year that his plan was in operation, which ended in June, the tax cuts had produced a staggering loss in revenue—$687.9 million, or 10.84 percent.... Brownback had also promised that his tax cuts would vault Kansas ahead of its higher-taxed neighbors in job growth, but that, too, failed to happen. In Kansas, jobs increased by 1.1 percent over the last year, compared with 3.3 percent in neighboring Colorado and 1.5 percent in Missouri....
Brownback would have been better off if the legislature had blocked his tax and spending cuts. Instead, in a year that should be a lock for a Republican in a brick-red state like Kansas, he is in danger of losing to a man who wasn’t even considered a top-tier Democratic candidate 18 months ago. It’s hard to imagine a more devastating testimony to the categorical failure of Brownback’s “real live” experiment. Davis is ahead by about four points in current public opinion polls. Still, he faces a tough battle.... Everyone expects Brownback and the various Koch satellites to throw hundreds of thousands into the race...
Over at Equitable Growth: Why I Am Coming to Think It Is Time to Dismantle the Eurozone and Restore North Atlantic Economic Policy Hegemony to Washington: Thursday Focus for October 2, 2014
Over at Equitable Growth: Paul Krugman: Ordoarithmetic: "Francesco Saraceno is furious and dismayed at Hans-Werner Sinn...
...who says among other things that deflation in southern Europe is necessary to restore competitiveness. Why not inflation in Germany, he asks? But Saraceno fails to understand German logic here. As they see it, their economy was in the doldrums at the end of the 1990s; they then cut labor costs, gaining a huge competitive advantage, and began running gigantic trade surpluses. So their recipe for global recovery is for everyone to deflate, gaining a huge competitive advantage, and begin running gigantic trade surpluses. You may think there’s some kind of arithmetic problem here, but in Germany they have their own intellectual tradition.
I would simply note that the German intellectual traditional of "ordoliberalism" grow up in the context in which somebody else--the United States--was managing global aggregate demand on Keynesian principles. READ MOAR
"Ordoliberalism" works fine if someone else is making Say's Law true in practice. The big problem is that as Germany's economy recovered from WWII, and as Germany became the linchpin of the European economy, things shifted enough that it needed to do its own aggregate demand stabilization. Yet when the United States stepped back from its role of global macroeconomic hegemon, it did not step back all the way: it did not nurture and accept the growth and increased power that the IMF--or some other agency--would need to do the job.
Once again, I am impressed at the smarts of Charlie Kindleberger. He said that at its root international economic turmoil and the Great Depression of the interwar period arose because Britain decided that it could no longer afford to be the hegemon, and the United States refused--until after World War II--to step forward to take its place.
Charlie warned us that we really needed to make sure that this did not happen again.
Well guess what?
As Barry Eichengreen and I wrote a year and a half ago in our preface to the reissue of Charlie's The World in Depression:
Barry Eichengreen and Brad DeLong: New Preface to Charles Kindleberger, The World in Depression 1929-1939: "Kindleberger predicted all this in 1973...
...He saw the power and willingness of the US to bear the responsibility and burden of sacrifice required of benevolent hegemony as likely to falter in subsequent generations. He saw three positive and three negative branches on the then-future's probability tree. The positive outcomes were: "[i] revived United States leadership… [ii] an assertion of leadership and assumption of responsibility... by Europe…” [sitting here, in 2013, one might be tempted to add emerging markets like China as potentially stepping into the leadership breach, although in practice the Chinese authorities have been reluctant to go there, and] [iii] cession of economic sovereignty to international institutions….” Here, in a sense, Kindleberger had both global and regional--meaning European--institutions in mind. “The last”, meaning a global solution, “is the most attractive”, he concluded,” but perhaps, because difficult, the least likely…" The negative outcomes were: "(a) the United States and the [EU] vying for leadership… (b) one unable to lead and the other unwilling, as in 1929 to 1933… (c) each retaining a veto… without seeking to secure positive programmes…"
As we write, the North Atlantic world appears to have fallen foul to his bad outcome (c), with extraordinary political dysfunction in the US preventing its government from acting as a benevolent hegemon, and the ruling mandarins of Europe, in Germany in particular, unwilling to step up and convince their voters that they must assume the task.
It was fear of this future that led Kindleberger to end The World in Depression with the observation: “In these circumstances, the third positive alternative of international institutions with real authority and sovereignty is pressing.”
Indeed it is, more so now than ever.
If, as indeed seems the case, Germany will not step up and exercise the responsibilities of mini-hegemon and be the aggregate demand balance wheel for the European Union, it is time for a constitutional change. The power to manage the North Atlantic economy as a whole needs to be centralized in Washington with the IMF, the Federal Reserve, and the U.S. Treasury taking on the role of trinitarian hegemon; the countries of Europe need to accept that since they will not lead they must follow; and the eurozone needs to be dismantled so that Frankfurt can no longer dictate improper exchange-rate policies to Madrid and Rome...
Hoisted from the Archives: New Preface to Charles Kindleberger: "The World in Depression"
The University of California Press has put out a new edition of Charles Kindleberger's World in Depression early next year.
J Bradford DeLong and Barry J. Eichengreen: New preface to Charles Kindleberger,* The World in Depression 1929-1939*:
The parallels between Europe in the 1930s and Europe today are stark, striking, and increasingly frightening. We see unemployment, youth unemployment especially, soaring to unprecedented heights. Financial instability and distress are widespread. There is growing political support for extremist parties of the far left and right.
Both the existence of these parallels and their tragic nature would not have escaped Charles Kindleberger, whose World in Depression, 1929-1939 was published exactly 40 years ago, in 1973.[1] Where Kindleberger’s canvas was the world, his focus was Europe. While much of the earlier literature, often authored by Americans, focused on the Great Depression in the US, Kindleberger emphasised that the Depression had a prominent international and, in particular, European dimension. It was in Europe where many of the Depression’s worst effects, political as well as economic, played out. And it was in Europe where the absence of a public policy authority at the level of the continent and the inability of any individual national government or central bank to exercise adequate leadership had the most calamitous economic and financial effects.[2]
These were ideas that Kindleberger impressed upon generations of students as well on his reading public. Indeed, anyone fortunate enough to live in New England in the early 1980s and possessed of even a limited interest in international financial and monetary history felt compelled to walk, drive or take the T (as metropolitan Boston’s subway is known to locals) down to MIT's Sloan Building in order to listen to Kindleberger’s lectures on the subject (including both the authors of this preface). We understood about half of what he said and recognised about a quarter of the historical references and allusions. The experience was intimidating: Paul Krugman, who was a member of this same group and went on to be awarded the Nobel Prize for his work in international economics, has written how Kindleberger's course nearly scared him away from international macroeconomics. Kindleberger's lectures were surely “full of wisdom", Krugman notes. But then, “who feels wise in their twenties?" (Krugman 2002).
There was indeed much wisdom in Kindleberger’s lectures, about how markets work, about how they are managed, and especially about how they can go wrong. It is no accident that when Martin Wolf, dean of the British financial journalists, challenged then former-US Treasury Secretary Lawrence Summers in 2011 to deny that economists had proven themselves useless in the 2008-9 financial crisis, Summers's response was that, to the contrary, there was a useful economics. But what was useful for understanding financial crises was to be found not in the academic mainstream of mathematical models festooned with Greek symbols and complex abstract relationships but in the work of the pioneering 19th century financial journalist Walter Bagehot, the 20th-century bubble theorist Hyman Minsky, and "perhaps more still in Kindleberger" (Wolf and Summers 2011).
Summers was right. We speak from personal experience: for a generation the two of us have been living – very well, thank you – off the rich dividends thrown off by the intellectual capital that we acquired from Charles Kindleberger, earning our pay cheques by teaching our students some small fraction of what Charlie taught us. Three lessons stand out, the first having to do with panic in financial markets, the second with the power of contagion, the third with the importance of hegemony.
First, panic. Kindleberger argued that panic, defined as sudden overwhelming fear giving rise to extreme behaviour on the part of the affected, is intrinsic in the operation of financial markets. In The World in Depression he gave the best ever “explain-and-illustrate-with-examples” answer to the question of how and why panic occurs and financial markets fall apart. Kindleberger was an early apostate from the efficient-markets school of thought that markets not just get it right but also that they are intrinsically stable. His rival in attempting to explain the Great Depression, Milton Friedman, had famously argued that speculation in financial markets can’t be destabilising because if destabilising speculators drive asset values away from justified, or equilibrium, levels, such speculators will lose money and eventually be driven out of the market.[3]
Kindleberger pushed back by observing that markets can continue to get it wrong for a very, very long time. He girded his position by elaborating and applying the work of Minsky, who had argued that markets pass through cycles characterised first by self-reinforcing boom, next by crash, then by panic, and finally by revulsion and depression. Kindleberger documented the ability of what is now sometimes referred to as the Minsky-Kindleberger framework to explain the behaviour of markets in the late 1920s and early 1930s – behaviour about which economists otherwise might have arguably had little of relevance or value to say. The Minsky paradigm emphasising the possibility of self-reinforcing booms and busts is the organising framework of The World in Depression. It then comes to the fore in all its explicit glory in Kindleberger’s subsequent book and summary statement of the approach, Mania, Panics and Crashes.[4]
Kindleberger’s second key lesson, closely related, is the power of contagion. At the centre of The World in Depression is the 1931 financial crisis, arguably the event that turned an already serious recession into the most severe downturn and economic catastrophe of the 20th century. The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial centre, Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver consequences, to London and New York. This is the 20th century’s most dramatic reminder of quickly how financial crises can metastasise almost instantaneously. In 1931 they spread through a number of different channels. German banks held deposits in Vienna. Merchant banks in London had extended credits to German banks and firms to help finance the country’s foreign trade. In addition to financial links, there were psychological links: as soon as a big bank went down in Vienna, investors, having no way to know for sure, began to fear that similar problems might be lurking in the banking systems of other European countries and the US.
In the same way that problems in a small country, Greece, could threaten the entire European System in 2012, problems in a small country, Austria, could constitute a lethal threat to the entire global financial system in 1931 in the absence of effective action to prevent them from spreading.
This brings us to Kindleberger’s third lesson, which has to do with the importance of hegemony, defined as a preponderance of influence and power over others, in this case over other nation states. Kindleberger argued that at the root of Europe’s and the world’s problems in the 1920s and 1930s was the absence of a benevolent hegemon: a dominant economic power able and willing to take the interests of smaller powers and the operation of the larger international system into account by stabilising the flow of spending through the global or at least the North Atlantic economy, and doing so by acting as a lender and consumer of last resort. Great Britain, now but a middle power in relative economic decline, no longer possessed the resources commensurate with the job. The rising power, the US, did not yet realise that the maintenance of economic stability required it to assume this role. In contrast to the period before 1914, when Britain acted as hegemon, or after 1945, when the US did so, there was no one to stabilise the unstable economy. Europe, the world economy’s chokepoint, was rendered rudderless, unstable, and crisis- and depression-prone.
That is Kindleberger’s World in Depression in a nutshell. As he put it in 1973:
The 1929 depression was so wide, so deep and so long because the international economic system was rendered unstable by British inability and United States unwillingness to assume responsibility for stabilising it in three particulars: (a) maintaining a relatively open market for distress goods; (b) providing counter-cyclical long-term lending; and (c) discounting in crisis…. The world economic system was unstable unless some country stabilised it, as Britain had done in the nineteenth century and up to 1913. In 1929, the British couldn't and the United States wouldn't. When every country turned to protect its national private interest, the world public interest went down the drain, and with it the private interests of all…
Subsequently these insights stimulated a considerable body of scholarship in economics, particularly models of international economic policy coordination with and without a dominant economic power, and in political science, where Kindleberger’s “theory of hegemonic stability” is perhaps the leading approach used by political scientists to understand how order can be maintained in an otherwise anarchic international system.[5]
It might be hoped that something would have been learned from this considerable body of scholarship. Yet today, to our surprise, alarm and dismay, we find ourselves watching a rerun of Europe in 1931. Once more, panic and financial distress are widespread. And, once more, Europe lacks a hegemon – a dominant economic power capable of taking the interests of smaller powers and the operation of the larger international system into account by stabilising flows of finance and spending through the European economy.
The ECB does not believe it has the authority: its mandate, the argument goes, requires it to mechanically pursue an inflation target – which it defines in practice as an inflation ceiling. It is not empowered, it argues, to act as a lender of the last resort to distressed financial markets, the indispensability of a lender of last resort in times of crisis being another powerful message of The World in Depression. The EU, a diverse collection of more than two dozen states, has found it difficult to reach a consensus on how to react. And even on those rare occasions where it does achieve something approaching a consensus, the wheels turn slowly, too slowly compared to the crisis, which turns very fast.
The German federal government, the political incarnation of the single most consequential economic power in Europe, is one potential hegemon. It has room for countercyclical fiscal policy. It could encourage the European Central Bank to make more active use of monetary policy. It could fund a Marshall Plan for Greece and signal a willingness to assume joint responsibility, along with its EU partners, for some fraction of their collective debt. But Germany still thinks of itself as the steward is a small open economy. It repeats at every turn that it is beyond its capacity to stabilise the European system: “German taxpayers can only bear so much after all”. Unilaterally taking action to stabilise the European economy is not, in any case, its responsibility, as the matter is perceived. The EU is not a union where big countries lead and smaller countries follow docilely but, at least ostensibly, a collection of equals. Germany’s own difficult history in any case makes it difficult for the country to assert its influence and authority and equally difficult for its EU partners, even those who most desperately require it, to accept such an assertion.[6] Europe, everyone agrees, needs to strengthen its collective will and ability to take collective action. But in the absence of a hegemon at the European level, this is easier said than done.
The International Monetary Fund, meanwhile, is not sufficiently well capitalised to do the job even were its non-European members to permit it to do so, which remains doubtful. Viewed from Asia or, for that matter, from Capitol Hill, Europe’s problems are properly solved in Europe. More concretely, the view is that the money needed to resolve Europe’s economic and financial crisis should come from Europe. The US government and Federal Reserve System, for their part, have no choice but to view Europe’s problems from the sidelines. A cash-strapped US government lacks the resources to intervene big-time in Europe’s affairs in 1948; there will be no 21st century analogue of the Marshall Plan, when the US through the Economic Recovery Programme, of which the young Charles Kindleberger was a major architect, extended a generous package of foreign aid to help stabilise an unstable continent. Today, in contrast, the Congress is not about to permit Greece, Ireland, Portugal, Italy, and Spain to incorporate in Delaware as bank holding companies and join the Federal Reserve System.[7]
In a sense, Kindleberger predicted all this in 1973. He saw the power and willingness of the US to bear the responsibility and burden of sacrifice required of benevolent hegemony as likely to falter in subsequent generations. He saw three positive and three negative branches on the then-future's probability tree. The positive outcomes were: "[i] revived United States leadership… [ii] an assertion of leadership and assumption of responsibility... by Europe…” [sitting here, in 2013, one might be tempted to add emerging markets like China as potentially stepping into the leadership breach, although in practice the Chinese authorities have been reluctant to go there, and] [iii] cession of economic sovereignty to international institutions….” Here, in a sense, Kindleberger had both global and regional – meaning European – institutions in mind. “The last”, meaning a global solution, “is the most attractive”, he concluded,” but perhaps, because difficult, the least likely…" The negative outcomes were: "(a) the United States and the [EU] vying for leadership… (b) one unable to lead and the other unwilling, as in 1929 to 1933… (c) each retaining a veto… without seeking to secure positive programmes…"
As we write, the North Atlantic world appears to have fallen foul to his bad outcome (c), with extraordinary political dysfunction in the US preventing its government from acting as a benevolent hegemon, and the ruling mandarins of Europe, in Germany in particular, unwilling to step up and convince their voters that they must assume the task.
It was fear of this future that led Kindleberger to end The World in Depression with the observation: “In these circumstances, the third positive alternative of international institutions with real authority and sovereignty is pressing.”
Indeed it is, more so now than ever.
References
Eichengreen, Barry (1987), “Hegemonic Stability Theories of the International Monetary System”, in Richard Cooper, Barry Eichengreen, Gerald Holtham, Robert Putnam and Randall Henning (eds.), Can Nations Agree? Issues in International Economic Cooperation, The Brookings Institution, 255-298.
Friedman, Milton (1953), “The Case for Flexible Exchange Rates”, in Essays in Positive Economics, University of Chicago Press.
Friedman, Milton and Anna J Schwartz (1963), A Monetary History of the United States, 1857-1960, Princeton University Press.
Gilpin, Robert (1987), The Political Economy of International Relations, Princeton University Press.
Keohane, Robert (1984), After Hegemony, Princeton University Press.
Kindleberger, Charles (1978), Manias, Panics and Crashes, Norton.
Krugman, Paul (2003), “Remembering Rudi Dornbusch”, unpublished manuscript, http://www.pkarchive.org, 28 July.
Lake, David (1993), “Leadership, Hegemony and the International Economy: Naked Emperor or Tattered Monarch with Potential?”, International Studies Quarterly, 37: 459-489.
Wolf, Martin and Lawrence Summers (2011), “Larry Summers and Martin Wolf: Keynote at INET’s Bretton Woods Conference 2011”, http://www.youtube.com, 9 April.
Notes
[1] Kindleberger passed away in 2003. A second modestly revised and expanded edition of The World in Depression was published, also by the University of California Press, in 1986. The second edition differed mainly by responding to the author’s critics and commenting to some subsequent literature. We have chosen to reproduce the ‘unvarnished’ 1973 Kindleberger, where the key points are made in unadorned fashion.
[2] The book was commissioned originally for a series on the economic history of Europe, with each author writing on a different decade. This points to the question of why the title was not, instead, “Europe in Depression.” The answer, presumably, is that the author – and his publisher wished to acknowledge that the Depression was not exclusively a European phenomenon and that the linkages between Europe and the US were also critically important.
[3] Friedman’s great work on the Depression, coauthored with Anna Jacobson Schwartz (1963), was in Kindleberger’s view too monocausal, focusing on the role of monetary policy, and too U.S. centric. See also Friedman (1953)
[4] Kindleberger (1978). Kindleberger amply acknowledged his intellectual debt to Minsky. But we are not alone if we suggest that Kindleberger’s admirably clear presentation of the framework, and the success with which he documented its power by applying it to historical experience, rendered it more impactful in the academy and generally.
[5] A sampling of work in economics on international policy coordination inspired by Kindleberger includes Eichengreen (1987) and Hughes Hallet, Mooslechner and Scheurz (2001). Three important statements of the relevant work in international relations are Keohane (1984), Gilpin (1987) and Lake (1993).
[6] The European Union was created, in a sense, precisely in order to prevent the reassertion of German hegemony.
[7] The point being that the US, in contrast, does possess a central bank willing, under certain circumstances, to acknowledge its responsibility for acting as a lender of last resort. Nothing in fact prevents the Federal Reserve, under current institutional arrangements from, say, purchasing the bonds of distressed Southern European sovereigns. But this would be viewed as peculiar and inappropriate in many quarters. The Fed has a full plate of other problems. And intervening in European bond markets, the argument would go, is properly the responsibility of the leading European monetary authority.
October 1, 2014
PIMCO: How to Lose (Lots of) Money and Still Influence People: The Honest Broker for the Week of October 10, 2014
Joshua Brown: “Do we need to fire PIMCO?”: "In February of 2011, [Bill] Gross loudly proclaimed...
[that] Pimco Total Return had taken its allocation to US Treasury bonds down to zero. As recently as the previous December, Pimco Total Return had been carrying as much as 22 percent of its AUM in Treasurys.... Gross compounded the move by being extremely vocal about his rationale--he went so far as to call Treasury bonds a 'robbery' of investors given their ultra-low interest rates and the potential for inflation. He talked about the need for investors to 'exorcise' US bonds from their portfolios, as though the asset class itself was demonic. He called investors in Treasury bonds 'frogs being cooked alive in a pot'. The rhetoric was every bit as bold as the fund’s positioning. It’s really hard to pound the table like this and then be flexible in the aftermath...
Yes, Bill Gross's judgment in February 2011 that U.S. Treasuries were overbought has been an absolute disaster for PIMCO's Total Return Fund vis-a-vis the market portfolio:
Holdings of ten-year U.S. Treasuries gained 20 cents on the dollar between Gross's bet and the summer of 2012, as interest rates collapsed in the summer of 2011 and took another lurch downward in the spring of 2012. (They recouped 14 of those cents between the summer of 2012 and the end of the summer of 2013 "Taper Tantrum", but today stand ten cents above their February 2011 value.
That being said, from Bill Gross's perspective the belief that bonds as of February 2011 were overbought must have been irresistible, and not for reasons that were clearly wrong at the time. Since the start of 2008, 10-year Treasuries had been trading in a 2.5%-4% range appropriate for a safe asset in a low-inflation economy on the edge of or in the midst of a significant depression:
But at some point relatively soon, it seemed to Gross back in 2011, the economy had to recover to something like normal--in which case 10-year Treasuries ought to return to their 4%-5% trading range of the post-dot.com era:
if not to their 5%-7% trading range of the fast-growth 1990s:
And, Bill Gross thought, there was already light at the end of the tunnel: the economy was recovering, and the only things keeping expectations of recovery over the next five years from pushing up 10-year Treasury rates now was that the Federal Reserve was artificially restricting the supply of 10-year Treasuries via quantitative easing. And so when QE II ended, Gross was confident, Treasury rates would jump sharply--and Treasury bondholders would lose bigtime.
So what went wrong? Why did Gross's expectations as of the winter of 2011 turn out to be so wrong? The standard answer is that long-term rates will not normalize until investors expect the normalization of short rates within half a decade, that short rates will not normalize until the Federal Reserve is confident that the zero lower bound crisis is over and will not return, and that that bond market confidence is further away now 3.5 years later than it was back in February 2011.
Paul Krugman is certainly the clearest exponent of this point of view--that it is all the immediate and obvious consequence of living in a liquidity-trap world:
Paul is certainly entitled to crow, crow some more, gloat, and crow yet again. He did write back before 2000 a book, The Return of Depression Economics, painting our current situation as not just a possible curious but even as a likely future scenario:
...While his personal behavior and management style may have been difficult, that’s hardly unusual among people in his position. All would have been forgiven... but for his utter misjudgment of the bond market in 2011... based on his failure, or more accurately refusal, to acknowledge the realities of a liquidity trap world.... Gross was by no means alone.... 2011 was a sort of banner year for bad macroeconomic analysis by people who had no excuse for their wrong-headedness. And here’s the thing: aside from Gross, hardly any of the prominent wrong-headers have paid any price for their errors.... Bowles and Simpson predicted a fiscal crisis within two years. There was never a hint of crisis, but BS are still given reverent treatment by the Beltway media.... Paul Ryan warned Ben Bernanke that he was “debasing” the dollar... the Bank for International Settlements made a similar argument, albeit with less Ayn Rand. They were completely wrong, but Ryan is still the intellectual leader of the GOP and the BIS is still treated as a fount of wisdom. The difference is, of course, that Gross had actual investors’ money on the line...
And:
Paul Krugman: The Pimco Perplex: "Neil Irwin says...
A disastrous bet [Bill Gross] made against United States Treasury bonds in 2011 led to three years of underperformance and billions in withdrawals.
And Joshua Brown has some choice quotes:
Gross compounded the move by being extremely vocal about his rationale--he went so far as to call Treasury bonds a “robbery” of investors given their ultra-low interest rates and the potential for inflation. He talked about the need for investors to “exorcise” US bonds from their portfolios, as though the asset class itself was demonic. He called investors in Treasury bonds “frogs being cooked alive in a pot.”
But why was Gross betting so heavily against Treasuries? Brad DeLong tries to rationalize Gross’s behavior in terms of a coherent story about an impending U.S. recovery.... But Gross was... claiming that the Fed’s asset purchases... were holding rates down.... So why did he believe all that? It all comes down, I’d argue, to liquidity trap denial. Since 2008 the basic logic of the economic situation has been that the private sector is trying to run a huge surplus, and the public sector isn’t willing to run a corresponding deficit. The result is an economy awash in desired savings with nowhere to go. This in turn means that budget deficits aren’t competing with private borrowing, and therefore need not drive up interest rates. This isn’t hindsight; it’s what I and others have been saying since the very beginning.
But a lot of people... have just refused to accept this account. They have clung to the view that budget deficits must lead to higher interest rates. You might think the failure of higher rates to materialize, year after year, would cause them to reassess.... Instead... [they] made excuses... if only the Fed weren’t buying up the stuff. So QE2 acquired a much bigger role in their thinking than it deserved.... You can see why I found Gillian Tett’s apologia for Gross--that he was blindsided by central bank intervention--frustrating.... Gross of all people shouldn’t have fallen into this trap, since his own chief economist understood liquidity trap logic better than almost anyone. But finance people seem weirdly determined to believe in a macro canon whose hold on their perceptions appears to be completely unbreakable, no matter how much money it causes them to lose...
But is that really an adequate answer?
You can draw your standard IS-LM, with its four pieces:
An LM Curve that shows the relationship between the safe nominal interest rate and the level of production as investors balance their money holdings they need to finance purchases against their bond holdings that yield them interest.
An IS Curve that shows the relationship between the real risky interest rate and the level of production as households and businesses react to interest-rate incentives to buy more or less and so keep factories running or idle.
The inflation wedge: the difference between nominal and real interest rates.
The risk-premium wedge: the difference between risky and safe interest rates.
It looks like this in the liquidity trap, at the zero nominal interest rate lower bound at which short-term bonds and cash money become perfect substitutes:
In the liquidity trap expansionary monetary policy--the Federal Reserve's buying bonds for cash and so pushing the LM Curve out and to the right does not do anything to the economy's equilibrium (unless it has knock-on effects that increase expected inflation or diminish the risk premium):
But expansionary fiscal policy--borrowing money and buying stuff--increases output and employment without raising interest rates as long as monetary policy is sufficiently accomodative:
But you can make Gross-like arguments in this diagram. If you forecast that rapid normalization will both reduce the risk premium and shift the IS Curve out as consumption and investment spending return to normal plus see government debt issue as increasing expected inflation, a liquidity trap now is perfectly consistent with high equilibrium nominal interest rates soon, and thus with long-term interest rates now that ought to be forward-looking, hence quickly normalizing:
From this perspective, Paul Krugman's 2011 declarations that we are in a liquidity trap now hence more deficits now will spur recovery without raising interest rates appeared to beside the point. Yes, that was true now. But in Bill Gross's world, spending and thus the IS Curve was going to normalize, this risk premium was going to normalize, and the flood of government debt issues were going to raise expected inflation. That all of these were going to happen meant that forward-looking long-term nominal interest rates should rise by a lot soon. That was Bill Gross's bet. And it went wrong.
So why? Why didn't risk premiums fall? Why didn't business and consumer spending normalize? Why didn't debt issue produce higher actual and expectations of inflation? I think we need a better answer than Krugman provides...
As I see it, Bill Gross made four analytical mistakes in the winter of 2011:
He had much too much confidence in the market economy's ability to stabilize the macroeconomy itself--or perhaps the government's desire and ability to stabilize the macroeconomy.
He draw an inappropriate parallel between the actions of individual investment banks that push asset prices away from fundamentals and the actions of a central bank.
He failed to properly understand the link between the diminished relative risk tolerance of bond investors and the price of Treasury bonds.
He failed to remember the Dornbusch Rule.
Let me run through all of these in turn:
(1) The Confidence Fairy
Bill Gross's first mistake, I think, is that he had been visited by the Confidence Fairy.
Look at the United States since 1948. Odds are, if the unemployment rate is above and employment and production are below their trend values, all three will get two-thirds of the way back to its trend value within two years. To bet on the American economy staying in the bust is almost surely to lose--at least, it is almost surely to lose until 2008 and thereafter. We can argue over whether the pre-2008 American economy possessed strong self-regulating equilibrating forces in its private-sector core or whether it was clever and effective monetary policy by the Federal Reserve that America's pre-2008 busts short and its inflationary-spiral booms--with the exception of the 1970s--short as well.
What is important to note is that, since 2008, this time things are different. Two years after the business-cycle trough of October 2009 the unemployment rate was not 2/3 but only 3/10 back to the previous normal. The recovery of output back to trend was even less: not 3/10 but 1/7. And the recovery of employment as a share of the adult population? Nowheresville.
If you expected a normal speed of recovery since 2009 and a normal speed of reversion of the Federal Reserve to normal interest rate policies, and if you bet on that speed of normalization, you lost your shirt--as PIMCO Total Return did. That said, this was an elementary error that Gross should have avoided: there was a great deal of evidence available as of early 2011 that this time was different as far as the speed of recovery was concerned.
(2) Risk Tolerance and Yield Spreads
Gross's third mistake, I believe, was failing to understand how 2008-2009 were likely to change the relationship among asset yield spreads.
The natural benchmark for a risk-free real return is the current short-run Treasury note rate minus the current inflation rate. What is the natural corresponding benchmark for a risky return? I have always taken it to be the permanent earnings yield on a broad stock market portfolio:
The real yields on bonds more risky than Treasuries and less risky than diversified common-stock equity investments move in the field of force defined by these two poles--the Treasury (real) rate and the common-stock yield.
It was conventional wisdom before 2008 that the spread between equity and Treasury yields was shrinking as a result of improvements in the desire and ability of investors to properly structure the risks that their portfolios were to bear--and the conventional wisdom after 2009 was that the financial crisis had not permanently deranged previous patterns. Gross was, therefore, looking forward to a near- and medium-term future in which equity yields would be on the order of 5%/year, inflation would be on the order of 2% to 3%/year, and the premium yield of equities relative to 5- to 10-year Treasuries would be on the order of 2% to 3%/year. That would mean that the 10-year Treasury annual yield would be attracted to something more than 5%.
He failed to properly understand the link between the diminished relative risk tolerance of bond investors and the price of Treasury bonds.
(3) The Dornbusch Rule
Bill Gross's third mistake, I believe, was to neglect the Dornbusch Rule. The Dornbusch rule is that your calculations of fundamentals may be accurate, and you may have high confidence in them, but nothing requires that the market has to have high confidence in your beliefs about fundamentals. Thus markets can remain far away from equilibrium for far longer than you, who understand and are dazzled by your analytical insights, think possible. As the spouse of one senior hedge-fund official put it: your theory of the world is that the market is inefficient when you put a trade on but will rapidly become efficient thereafter--where "rapidly" means "before your clients lose their patience with you". Bill Gross forgot that. And that is one reason that he put his bet on not with trepidation and with statements about how the balance of risks suggested underweighting Treasuries, but rather with the extravagant rhetoric that left his reputation hostage to the trade turning out well.
(4) The Washington Super-Whale
I wrote about this before, in a similar context, a year and a half ago. Bill Gross and those who thought like him faced a world in the aftermath of the financial crisis in which (a) they expected a return to normal levels, (b) they were confident that modern financial engineering would drive a return to small spreads, and (c) they believed the market rational enough to in short order adopt their view of fundamentals and push asset prices to the fundamental configuration. Yet, as of early 2011, it had not happened. Why not?
The natural answer if you are a financier to why prices stubbornly refuse to return to fundamentals is that one of two things are happening: (a) sentiment has gone mad and there is a--positive or negative--bubble; or (b) some huge trader is taking on a very risky and almost surely losing position because of the price pressure the enormous size of their bet is creating. And in the aftermath of the financial crisis, it seemed obvious that it was (b), and that the enormous trader was the Federal Reserve.
We saw what Bill Gross and company thought was going on in 2011 play out in miniature, with JPMC in the role in which they had cast the Federal Reserve, the following year. In February 2012, traders noted one particular underpriced index--CDX IG 9. There was an obvious short-term moneymaking opportunity: Buy the index, sell its component short, in short order either the index will rise or the components will fall. But April rolled in, and the gap between the price of CDX IG 9 and what the traders thought it should be grew. Their bosses asked them questions: "Shouldn't this trade have converged by now?" "Have you missed something?" "How much longer do you want to tie up our risk-bearing capacity here?" "Isn't it time to liquidate--albeit at a loss?" So the traders began asking who their counterparty was, and found he was singular--"the London Whale". So they got annoyed. And they went public, hoping that they could induce the bosses of the London Whale to force him to unwind his--very risky--position. And so we had "'London Whale' Rattles Debt Market" and similar stories.
The London Whale was Bruno Iksil. His boss, Ina Drew, took a look at his positions and found that JPMC had a choice: They could hold CDX IG 9 until maturity while singing "Luck, Be a Lady Tonight!" and bet JPMC on a single crapshoot--make a fortune if a fewer-than-expected number of the index's 125 companies went bankrupt and lose JPMC to bankruptcy if more did--or they could eat a $6 billion loss and go home. Since JPMC could not survive in the absence of an unlikely government bailout if its net worth went negative even for a day, Drew stood Iksil down and the traders had their happy ending.
What Bruno Iksil did was what Bill Gross--and Cliff Asness, and a huge host of other Wall Streeters--thought that Ben Bernanke was doing. He had run the Federal Reserve's balance sheet up to absurd proportions, and in so doing had pushed interest rates well below and Treasury and MBS bond prices well above fundamentals. Eventually, and sooner rather than later, Gross and Asness and company thought, the Federal Reserve would have to revert and unwind its grossly overleveraged position--and when it did so it and everybody else long Treasury bonds would lose a fortune, and those smart enough to bet on fundamentals by shorting Treasury bonds would profit.
Bruno Iksil had been pulled up short by his boss Ina Drew's unwillingness to hold his positions to maturity and so risk JPMC's bankruptcy. Ben Bernanke, they thought, ought to have been pulled up short by his unwillingness to risk an inflationary spiral--for Bernanke had financed his Treasury bond purchases by issuing reserve balances, and when banks became confident enough to diminish their excess reserves by using them to back deposits and when businesses and households became confident enough to spend those deposits, then there would be a devastating inflationary spiral unless the Federal Reserve had previously unwound its position. It was, they appear to have thought, unprofessional for Ben Bernanke not to have already unwound his positions as of the winter of 2011 and for him to in fact be adding to them via QE II. Thus, I think, one purpose of Bill Gross's bet and declaration was to do to Ben Bernanke what the following year's leaks about 'the London Whale' did to Bruno Iksil: force recognition of the extraordinary risks Bernanke was running, and so start the unwinding of the Federal Reserve's balance sheet, and so trigger the return of bond prices and interest rates to fundamentals.
The problem, of course, is that the parallel is faulty. If JPMC has a moment of negative net worth, it is toast. If JPMC's positions have pushed asset prices far enough away from fundamentals that it is perceived to in the future have a significant chance of giving it a negative net worth, it is also toast: the fact that the first people to unwind their positions vis-a-vis JPMC get out whole while those who do not may not triggers a shadow bank run on JPMC's non-inertial liabilities, and in order to cope with that run JPMC has to liquidate assets at fire-sale prices and that triggers the negative net worth that was feared as a future possibility. There is thus a very sharp and direct chain of actions with very hard incentives at every stage leading from too-much leverage to catastrophe.
By contrast, if the Federal Reserve's purchases are perceived as having pushed asset prices away from fundamentals--or, rather, "fundamentals"--well, then what? Some people sell Treasuries and buy other assets--equities, say--in an attempt to profit from the forthcoming return of interest rates to "fundamentals", and then what? Others have the cash that the Fed issued to finance its born purchases in their pockets, and they wonder if they should spend it, and then what? Well, nothing--except to the extent that businesses with higher stock prices decide that they can afford to cut back on share repurchases and employ more people to build capacity instead, and except to the extent that those with the extra cash don't just wonder but actually increase their spending. And if they do? Then the economy recovers. Strong market reactions to Bruno Iksil's position would be the source of catastrophe for JPMC; strong market reactions to the Federal Reserve's QE policies would--if they were to occur--be the desired effect of the Federal Reserve's policies.
But doesn't the Federal Reserve have to unwind its balance sheet? After the economy has recovered to a normal level of activity, yes. But won't the Federal Reserve lose a fortune when it does so? Yes--but so what? The Federal Reserve does not have real shareholders, and does not have a real fiduciary duty of wealth maximization to the fake shareholders it has. If when the Federal Reserve has finished unwinding its position in order to keep inflation from accelerating and finds that it has no assets and $1 trillion of liabilities in the form of Federal Reserve notes and reserve deposits outstanding, so what? The reserve deposits are valuable because they allow you to accept commercial bank deposits. The Federal Reserve notes are valuable because you can pay your taxes with them. It's not the same with the liabilities of JPMC, which are of very dubious value if JPMC is or is feared to possibly in the future be bankrupt, for which the lack of secure fundamental value as JPMC approaches bankruptcy creates the possibility of terrifyingly rapid and destructive bank runs. Demand for a private bank's liabilities can collapse quickly and suddenly in a bank run. Demand for a central bank's liabilities cannot--especially when the central bank's liabilities are a reserve currency.
It was, I think, this faulty analogy between a private investment bank that has over-expanded its balance sheet by purchasing some asset class on a large enough scale and so pushed prices away from fundamentals and the Federal Reserve's balance sheet expansion that, I think, played a key role in Bill Gross's analytical error. But that was just the final miscalculation. Before it came (a) misjudgments about the speed with which normalcy would be reattained, (b) misjudgments about what risk yield spreads would be when and if normalcy were to return, and (c) misjudgments as to how long the market could stay out-of-equilibrium--longer, as John Maynard Keynes does not appear to have said, than Bill Gross could remain if not solvent at least in charge of PIMCO Total Return.
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links to things you think people ought to read.
praise of others.
laments that you have been misinterpreted, and that all nuance has been lost because of the limits of 140 characters.
For example, last week:
@jacobwe: New "plagiarism" charges against @FareedZakaria are silly.
@jacobwe: Here's the full @FareedZakaria rap sheet. Totally off base, IMO. http://t.co/3livp8ilkl
@blippoblappo: Hey Jacob, is Fareed Zakaria plagiarizing in a Slate column "silly" to you? https://ourbadmedia.wordpress.com/2014/09/24/yes-the-indefensible-fareed-zakaria-also-plagiarized-in-his-fancy-liquor-columns-for-slate/ @jacobwe @fareedzakaria
@crushingbort: Yes, The Indefensible Fareed Zakaria Also Plagiarized In His Fancy Liquor Columns For Slate http://wp.me/p4QYzT-4h
@blippoblappo: If @jacobwe doesn't think things like this are worthy of a retraction of a Zakaria column in Slate, what is?
@blippoblappo: hey @BenMathisLilley you should probably shoot an email with this & your previous great article on Zakaria's plagiarism to bossman @jacobwe
@squarelyrooted: < 28 hrs from @jacobwe pooh-poohing @blippoblappo & @crushingbort's evidence of @FareedZakaria's plagarism and them finding more - in @Slate
@blippoblappo: @squarelyrooted @jacobwe @crushingbort @fareedzakaria @slate it actually took about 30 minutes to find the plagiarism, another day to write
@jacobwe: @blippoblappo You take a source he CITES, then point to info that comes from that source, differently phrased. Not remotely plagiarism.
@garonsen: @jacobwe @blippoblappo The info comes 300 words later in the story in a separate paragraph, bit of a stretch to call that a proper citation.
@nickLbrothers: @garonsen @blippoblappo @jacobwe & a paraphrase should be summation even w/ cite, not switching two words out for synonyms.
@jacobwe: @blippoblappo When it comes to TV, I've got news for you. TV personalities say things they don't write themselves. The even hire "writers."
@jacobwe: @blippoblappo Also, your bullying vigilantism is pure J. Edgar Hoover: If you challenge us, we'll investigate YOU. Sorry, not intimidated
Now Jacob Weisberg is on record as stating that his Slate's "investigations" are intended adversarial takedowns rather than truth-finding exercises of journalism. Really not something that he would have wished to have done under any circumstances, and really not a smart career move at all...
Liveblogging World War I: October 1, 2014: The Battle of Arras
Battle of Arras (1914) - Wikipedia:
The Tenth Army, led by General Louis Maud'huy, attacked advancing German forces on 1 October and reached Douai, where the German 6th Army under Crown Prince Rupprecht counter-attacked, as three corps of the German 1st, 2nd and 7th armies attacked further south. The French were forced to withdraw towards Arras and Lens was occupied by German forces on 4 October. Attempts to encircle Arras from the north were defeated and both sides used reinforcements to try another flanking move further north at the Battle of La Bassée.... The reciprocal flanking moves ended in Flanders, when both sides reached the North Sea coast and then attempted breakthrough attacks....
On 28 September, Falkenhayn ordered that all available troops were to be transferred to the 6th Army, for an offensive on the existing northern flank by the IV, Guard and I Bavarian corps near Arras, an offensive by the II Cavalry Corps on the right flank of the 6th Army, across Flanders to the coast and an acceleration of the operations at the Siege of Antwerp, before it could be reinforced. Rupprecht intended to halt the advance of the French on the west side of Arras and conduct an enveloping attack around the north of the city....
A French division arrived at Arras on 30 September and repulsed a German attack at the Cojeul river and high ground near Monchy-le-Preux on 1 October. The French were then slowly pushed back from Guémappe, Wancourt and Monchy-le-Preux until the arrival of X Corps. The French XI Corps was withdrawn from the Ninth Army and sent to Amiens; by 1 October two more corps, three infantry and two cavalry divisions had been sent northwards to Amiens, Arras, Lens and Lille, which increased the Second Army to eight corps, along a front of 100 kilometres (62 mi). Joffre ordered Castelnau to cease attempts to outflank the Germans opposite and operate defensively. From the northern corps of the Second Army and the Territorial and cavalry divisions nearby, created a Subdivision d'Armée under the command of General Louis de Maud'huy. The Subdivision advanced on Arras, with the gap south to the Second Army held by the Territorial divisions.[10] Maud'huy was ready to begin an attack to the south-east past Arras and Lens, under the impression that the Subdivision was opposed only by a cavalry screen, rather than three German corps which were preparing to attack.
The westward advance of the XIV Reserve Corps, from Bapaume to Albert and Amiens, was stopped by French troops east of Albert. Five German cavalry divisions further north, were also confronted French cavalry and infantry.... The 1st Guard Division and IV Corps were moved to the northern flank of the XIV Reserve Corps, to allow some of the cavalry divisions to redeploy.... The 5th Bavarian Reserve Division advance was stopped by French troops at Lewarde, 6 kilometres (3.7 mi) short of Douai, until the village was captured in the evening, after which the division stopped for the night. The 1st Bavarian Reserve Division battalions also came within 6 kilometres (3.7 mi) of Douai.... The advance resumed on 2 October, with the 1st Bavarian Reserve Division in the south, attacking through Brebières to St. Laurent and the 5th Bavarian Reserve Division to advance via Izel and Oppy to Bailleul-Sir-Berthoult.... By the morning of 3 October, the German front line ran from Drocourt to Bois Bernard and Fresnoy.... The advance on Arras continued, supported by artillery moved forward during the night and the Guard, 4th, 7th and 9th Cavalry divisions in the Scarpe valley.... Costly German attacks were made on Beaurains, Mercatel and the Arras suburbs of St. Laurent-Blangy and St. Nicolas....
On 4 October, Joffre made the Subdivision d'Armée independent as the Tenth Army and told Castelnau to keep the Second Army in position, relying on the increasing number of French troops arriving further north to divert German pressure. Foch was appointed as a deputy to Joffre, with responsibility for the northern area of operations, the Territorial divisions, the Second and Tenth armies, which were combined in the Groupe Provisoire du Nord (GPN)....
The French had been able to use the undamaged railways behind their front to move troops more quickly than the Germans, who had to take long detours, wait for repairs to damaged tracks and replace rolling stock.... The initiative held by the Germans in August was not recovered as all troop movements to the right flank were piecemeal.... Information on German troop movements from wireless interception enabled the French to forestall German moves but the Germans had to rely on reports from spies, which were frequently wrong. The French resorted to more cautious infantry tactics, using cover to reduce casualties and a centralised system of control as the German army commanders followed contradictory plans. The French did not need quickly to obtain a decisive result and could concentrate on preserving the French army.
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