Public emanations from PIMCO in recent weeks have us scratching our heads (which is still preferable to having them ripped off, as Bill Gross recently warned could happen).
The first salvo was Gross's "Off With Our Heads!" piece in which he wrote that "all investors should fear the consequences of mindless U.S. deficit spending as far as the mantis eye can see. Higher inflation, a weaker dollar and the eventual loss of America’s AAA sovereign credit rating are the primary consequences. Fear your head – fear your head."
The latest is a WSJ op-ed by ex-Treasury and TARP official Neel Kashkari, in which he claims that markets are flashing warning signals for Treasury debt. He has followed up with public comments, such as his Jan. 18 interview with Bloomberg TV.
Clearly, there's a concerted PR push by the PIMCO folks. But why? We can't answer that (the third stanza below might give a clue) but we can at least take a stab at the validity of their arguments.
Gross claims that:
- American wages will lag behind CPI and commodity price gains. An ongoing rebalancing of rich country/poor country wages inevitably will keep U.S. wages compressed as deficit spending serves to reflate commodity and end product prices in future years but not paychecks.
- Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the global valuation of dollar-denominated assets. Annual budget deficits in the trillions of dollars add a like amount to the stock of outstanding dollars, resulting in currency depreciation, higher import inflation, and a degradation of dollar-based assets in global financial markets.
- One of the consequences of perpetual trillion dollar deficits is the need to finance them, and at attractively low interest rates, for as long as possible. Currently, the Fed is doing both, holding short-term interest rates near zero, and engaging in Ponzi-like Quantitative Easing II purchases of longer-dated Treasuries in the open market. The combination offers bondholders about as attractive a situation as the one facing a male praying mantis: Zero percent interest rates if you stay in cash, or probable principal losses if you take durational risk by buying 5- and 10-year maturities. Eventually, as reflationary policies take hold, long-term bondholders lose their heads (and a portion of their principal as well) as yields rise to reflect higher future inflation. Bondholders’ metaphorical warning: “Don’t go near those longer term bonds, you fool.”
- Trillion dollar annual deficits add up, and eventually produce a stock of debt that can become unmanageable. Witness Greece, Ireland, or a host of Latin American countries of generations past. According to Carmen Reinhart and Kenneth Rogoff’s excellent research in This Time Is Different, once a country’s debt approaches 90% of GDP (as the U.S. is now doing), its economic growth slows by up to 1% annually as the interest payments drain resources that should be going for productivity enhancements. Sovereign credit risk increases and yield spreads rise relative to global competitors. Future generations pay the price for their parents’ mindless thrusting.
Kashkari claims that (1) Treasury markets are as complacent as residential mortgage markets were in the run-up to the financial crisis, and (2) U.S. Treasuries could experience a sudden loss of confidence as certain countries of the eurozone have.
Where to start? These are smart guys, but they're really playing fast and loose on this subject (which is why we're wondering aloud about their motivation(s)). For example, in Gross' second point above, he seems to understand that federal budget deficits are today's analogue to 19th century gold mines. Did those perpetual "deficits" run by gold mines always lead to gold and currency depreciation? Hardly. There is simply no way for Gross, Kashkari, or anyone else to know what the cumulative deficit level is that will -- all else being equal -- lead to significant currency depreciation or inflation. Importantly, all else won't be equal as long as other nations pursue industrial policies that require them to make dollars worth less than mere U.S. budget deficits would cause them to be.
Despite Gross' apparent understanding that federal budget deficits supply money to the private and sub-federal government sectors of the economy, he then claims that deficits need to be financed. Huh? U.S. government spending is decidedly not limited by the government's ability to tax or borrow. Taxes are remitted out of prior government spending, and the issuance of Treasury debt is essentially nothing more than a swap of financial assets from non-interest-bearing government obligations to interest-bearing ones. And QE2 a Ponzi scheme? I don't know what kind of mantis heads they're eating out there, but they're experiencing some paranoid and conspiratorial delusions.
In his fourth point, Gross again shows that despite seeming to get it, he really doesn't get it. U.S. government deficits do not have to be financed, period. It's nice to have different forms of government financial assets in the system, but that doesn't mean that the U.S. Treasury has to borrow a damned thing. It simply agrees to accept dollars that is has deficit-spent in the past in order to extinguish some liability to the federal government that exists in another sector of the economy.
It's also a bit ironic for Gross to assail federal deficits when he candidly admits that the world economy is struggling with insufficient aggregate demand. It's fine to question the nature of the spending that produces federal deficits, but to question deficits themselves under such conditions is utterly inconsistent. That the reality of U.S. Treasury spending and taxation is the reverse of our prevailing common sense should also expose the oft-made but groundless claim repeated by Gross that future generations will be "saddled" by today's federal deficits. That is as baseless as saying that under the classical gold standard, future generations had to endure the burden of re-burying every grain of gold that had ever been mined into above-ground existence. It's what Warren Mosler would call an innocent but harmful falsehood (pdf).
As for Kashkari's comments, I haven't seen his op-ed yet, but there wasn't a damned thing in the visuals supporting his interview that indicated any kind of "warning sign" for Treasury markets or U.S. creditworthiness. (Perhaps he's referring to credit default swaps on U.S. Treasury debt, in which case he's taking way too generous a view of our profession.) Both he and Gross are simply dead wrong to suggest that the U.S. is anything like a eurozone member country. Of course, as has already happened in Europe, U.S. policymakers might choose to impose such a condition upon the rest of us -- by refusing to raise the federal debt ceiling, for example -- but there is no practical or compelling need to.
The bottom line is that the U.S., Japan, and the U.K. (and the eurozone to some extent) are unlike almost all of the countries in the Reinhart and Rogoff sample -- it's an apples to oranges comparison, and thus the magical "90% debt-to-GDP" metric means nothing without further study -- nothing. And rather than (inanely) comparing the U.S. to residential mortgages or the eurozone's periphery, Gross and Kashkari should admit that Japan is the most relevant historic example for concerns about the future of U.S. finances -- and none of their dire predictions have come to pass there.
While the yen carry trade fueled commodity speculation for a time, that's a problem of global financial regulation and coordination, and has nothing at all to do with sovereign deficits. Of course, the U.S. could take these enlightened gentlemens' advice and follow the U.K.'s austerity route, but then there would be more heads to worry about than just praying mantises'.
It would surprise me if they didn't understand all of this. Perhaps they're just talking their book? PIMCO is touted as the world's largest bond manager, after all, and neither one of them sounds too happy about the air pocket recently encountered by Treasury markets. But it seems very clear that that market turbulence was the result of improved economic expectations, not heightened inflation or default fears -- which means that PIMCO's running the risk of sounding awfully disingenous on issues like wages.
There's plenty of this toxic reasoning circling the world nowadays. As an antidote to PIMCO's recent contributions, we suggest numbers one, two, and three of Mosler's deadly innocent frauds (our comments in brackets):
Seven Deadly Innocent Frauds of Economic Policy
1. The government must raise funds through taxation or borrowing in order to spend. In other words, government spending is limited by its ability to tax or borrow. The federal government can always make any and all payments in its own currency, no matter how large the deficit is, or how few taxes it collects [even with no alleged "Ponzi scheme" buying by the Fed].
2. With government deficits, we are leaving our debt burden to our children. Collectively, in real terms, there is no such burden possible. Debt or no debt, our children get to consume whatever they can produce [and if under certain conditions larger deficits are more optimal than smaller ones, then smaller deficits will impose real opportunity costs on future generations].
3. Government budget deficits take away savings. Federal Government budget deficits add to savings. [This one may sound strange, but remember that the federal budget is today's analogue to 19th century gold mines -- then, perpetual "dissaving" by gold mines perpetually added to savings. No one ever thought that the mines were crowding out savings elsewhere in the economy by running deficits of gold. Yet today, the vast majority of economists believe something just as ludicrous.]
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.