Jared Bernstein: How the Jobless Rate Underestimates the Economy’s Problems: “Why not just look at the unemployment rate and call it a day?…

…Because special factors in play right now make the jobless rate an inadequate measure of slack. In fact, at 6.1 percent last month, it’s within spitting distance of the rate many economists consider to be consistent with full employment, about 5.5 percent…. First, there are over seven million involuntary part-time workers… up two percentage points from its pre-recession trough… the unemployment rate doesn’t capture this dimension of slack at all…. Second… participation…. Economists have scurried about trying to figure out how much of the three-percentage-point decline in the labor force participation rate… to attribute to… structural… factors…. Jan Hatzius… another 1.6 million people worth of slack…

Must- and Shall-Reads:

• Mark Zandi: Job creation key to economic comeback

 

1. 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.”

2. 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.”

3. 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.”

4. 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.”

5. 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…”

Should Be Aware of:

• Justin Fox: Understanding China’s Hard Line on Hong Kong

 

1. 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…”

2. 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.”

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.

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.

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–United States–was managing global aggregate demand on Keynesian principles. “Ordoliberalism” works fine if someone else is making Say’s Law true in practice. The big problem is that Germany’s economy recovered and Germany became the linchpin of an economy large enough that it needed to do it’s own aggregate demand stabilization, and win 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 innerwar period arose because Brittany 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 it’s 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 aggregate demand a 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.

PIMCO: 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:

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:

1. 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.
2. 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.
3. The inflation wedge: the difference between nominal and real interest rates.
4. 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:

1. 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.

2. 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.

3. He failed to properly understand the link between the diminished relative risk tolerance of bond investors and the price of Treasury bonds.

4. 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%.

1. 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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Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers: Government Debt Management at the Zero Lower Bound: 

Goals:
1. Quantify Fed vs. Treasury conflict in QE era.
2. Fed vs. Treasury in historical perspective.
3. A modern framework for debt management.
4. Ways to resolve Fed vs. Treasury conflict.


Pulling in Opposite Directions:
* The Fed’s Quantitative Easing (QE) policies have reduced the net supply of long-term securities.
* Meanwhile the Treasury was doing the opposite, extending the average maturity of its borrowings.
* Effect on Supply: Ten-Year Duration Equivalents:
* Federal Reserve: Quantitative Easing: -10.6%.
* Treasury: Maturity Extension +5.6%.
* Net Impact: -10.1%.


Market Impact:
* Relying on prior studies, we estimate that the Fed’s QE policies have lowered the yield on 10-year Treasuries by a cumulative 1.37 percentage points.
* Treasury’s maturity extension may have offset as much as one-third of QE’s market impact.
* Before 2008, the Fed’s balance sheet was far smaller. As a result, the Fed had little impact on the maturity structure of the
government’s consolidated debts.


Traditional Debt Management:
* Treasury’s traditional approach to determining the appropriate maturity of the debt traded off a desire to achieve low cost financing against the desire to limit fiscal risk.
* Issuing short-term is “cheaper” because it allows Treasury to capture the “liquidity premium” on T- bills and to conserve on the “term premium” investors demand to hold long bonds.

Fiscal Risks:
* Refinancing risk: if the government issues short-term, it is exposed to increases in interest rates; if the government issues long-term, it ‘locks in’ the cost of capital.
* Rollover risk: failed auctions and self-fulfilling bank runs.
* The desire to limit fiscal risk looms larger when the overall debt burden rises.
* Thus, Treasury has historically tended to extend the average maturity of the debt when debt-to-GDP ratio rises. Much like the Treasury is doing today.

Quantifying Fiscal Risk:
* We argue that the “fiscal risk” generated by issuing short-term debt is less important than traditionally thought:
* A standard deviation of debt-service costs of less than 1.5% of GDP.
* Purchased at an average price in excess average interest of 0.8% of GDP.
* Modern debt management recognizes that the maturity of government debt may also be a valuable tool for managing aggregate demand and promoting financial stability.
* Objectives of modern debt management have been assigned to Treasury and Fed, which exercise different policy weights.

Debt Management Conflicts:
* Expansionary monetary policy at ZLB
* Treasury extends average duration to mitigate fiscal risk.
* Fed shortens average duration to bolster aggregate demand.
* Fed and Treasury in direct conflict over objectives.
* Under contractionary monetary policy.
* The rise in premium on money-like assets increases the Treasury’s incentive to issue short.

Solving the Conflict:
* Outside of the zero-lower-bound, Fed sterilization of Treasury debt management is imperfect workaround.
* Fed gets last word using short rate.
* But sterilization no longer possible at the ZLB.
* Better solution: Treasury and Fed release annual joint statement on combined public-debt management strategy.
* Forces each agency to internalize other’s objectives.
* Fed charged with routine tactical adjustments because of its expertise in open-market operations.



Commenting, Federal Reserve Governor Jerome Powell appears to have said (i) that since quantitative easing had only minimal effects, its partial offset by the Treasury was no big deal, and (ii) requiring the Fed and the Treasury to talk to each other about debt maturity would infringe on the Federal Reserve’s autonomy by getting the Treasury unduly involved in monetary policy. His point (ii) I do not understand: the problem is that the Treasury’s debt-management already involves the Treasury in monetary policy, and coordination does not create that problem but merely recognizes it (and tries to mitigate it). His point (i) is strongly contested: the claim that the effects of quantitative easing have been minimal is an item of active debate where it seems to me that Powell is probably on the losing side.

Commenting, former Treasury Undersecretary for Domestic Finance Mary John Miller said that more cooperation would be highly problematic, but that she would not be surprised if in the future the Treasury revised what has been the Geithner-Lew debt maturity extension policies.

Commenting, Jason Cummins said that Fed-Treasury coordination would open the door to episodes like, as Binyamin Applebaum related it, “President Johnson’s summoning the Fed’s chairman, William McChesney Martin, to his Texas ranch, slamming him against the wall and telling him, ‘Martin, my boys are dying in Vietnam, and you won’t print the money I need.'”

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.”

1. Lives lost from Ebola to date are tiny, even in west Africa, compared to HIV, TB, and malaria. Ebola still not (yet) the biggest public health problem in West Africa.

2. Yes, the epidemic will spread to more countries.

3. Ebola will not become the biggest public health problem in West Africa unless deaths reach the high seven figures–which they may: it is highly likely that deaths in the six figures are now baked in the cake.

4. Unless the virus changes dramatically, we are almost surely safe. If you want to worry, worry that influenza or something already airborne will become more deadly, not that Ebola will become airborne.

5. Those at risk from the Ebola virus are overwhelmingly (a) those who love them and (b) those medical professionals who treat them–you get it from direct fluid contact with symptomatic patients. Thus risks here in the United States are very low. It is scary, but unlikely to be a serious problem here.

6. Why, then, are risks high in West Africa? The major problem with control is that there is no functioning health system in most of sub-Saharan Africa. Not only are resources poor, but they are uncoordinated. What we really need is a helicopter drop of trained people.

7. The health system was especially poor in Liberia. You have issues like no supply of gloves to hospitals. Few doctors even to begin. Had the epidemic started in Ethiopia or even Uganda, the probability of it getting out-of-control epidemic would have been much less–Uganda, for example, has excellent hospitals, good supply, competent public health, and even a decent medical school. Just how bad Liberia’s system was should not be underestimated.

8. Secondary problems in West Africa are that: (1) Ebola can be difficult to diagnose; (2) Ebola is easily transmitted in cultures where people are expected to die at home in non-sterile and non-antiseptic environments; and (3) Ebola is easily transmitted in cultures where people–still infectious–are prepared for burial at home.

9. The economic cost of Ebola to the countries most affected is and will be immense, in addition to the loss of life.

10. In general, we are not well-equipped for some types of global pandemics. The advance from years of nothing on AIDS to stopping SARS in its tracks was immense. But it relies on functional organizations–and we did and do not have any such in the affected West African areas.

11. Nevertheless, it is surprising how unprepared the WHO and international community was for for this kind of emergency. The WHO is a UN organization, and it is a mistake to expect much bureaucratic competence of UN organizations. Nevertheless, the international response should have been swifter and more effective.

12. The Ebola crisis is eating up resources in West Africa that are desperately needed in other areas of health and society. It’s not so much money as people–doctors pulled in from caring for pregnant women to manage Ebola patients, NGOs working on violence reduction in Sierra Leone now counting the dead. Really sad. We are likely to lose most of the health-care professionals in the most severely affected sub-Saharan African countries.

13. The importance of investing in strong public health infrastructure–which is both massively underfunded and very cost-effective compared with acute care.

Courtesy of Chris Blattman, David Cutler, Ann Marie Marciarille, and others…