When Smart People Are Wrong

In a recent interview (July 16th), Roger Lowenstein recommends that investors sell bonds “yesterday”.

Nassim Taleb claimed earlier this year that ”It’s a no-brainer. Every single human being should have that trade: short Treasury bonds in the U.S.” (quoted on p. 22 in the August 2010 issue of Smart Money; see also http://www.bloomberg.com/apps/news?pid=newsarchive&sid=azLmks3BmQm4)

Lowenstein sees parallels to the 1970s (according to Bloomberg, Taleb did not elaborate on the rationale behind his statement). As our recent interview with Diane Macunovich shows, the 1970’s are a poor benchmark for today. The experiences of the U.S. in the 1930s and Japan since 1990 are far more relevant. And in both periods shorting domestic treasury debt was a “black widow” trade.

There may well be a time during Lowenstein’s and Taleb’s lives when U.S. Treasuries lose significant value. But barring large, forceful, and persistent fiscal stimulus, that time is not now.

Rob Arnott, another smart guy, is (like many other smart people) sweating U.S. deficits and debt, claiming that the U.S. has “a government and a society addicted to debt financed consumption.” He asserts that GAAP accounting would put total U.S. federal debt at 800% of GDP, and predicts several inflationary shocks in the decades ahead, recommending inflation insurance such as TIPS and commodities. He’s absolutely right that one should buy insurance when it’s cheap, but to estimate the value of insurance, you need to estimate the probability of whatever outcome you’re insuring against. Arnott clearly believes that it’s almost a sure thing U.S. inflation will run above the current premium on TIPS.

However, we place a far higher probability on the U.S. following a path similar to Japan’s in the decade ahead. Thus, investors should be prudent about how much they’re willing to “spend” — in foregone nominal returns on other securities – for inflation insurance. There is no free lunch, after all. Insurance always costs something.

Besides the similarities to Japan’s situation a decade earlier, competing macro frameworks also argue against the inflation bulls and Treasury bears. The alternate view of deficits, debt, and inflation was captured well in a recent paper from the Levy Institute entitled “Uncle Sam Won’t Go Broke”:

Many investors, policymakers, and economists take it as fact that soaring government debt inevitably leads to inflation. This fear comes in several versions. Sometimes the emphasis is on the prospect of a stealth default by the government as inflation shrinks real debt service payments; sometimes it is on the consequences of serious future inflation for the economy as a whole. Many analysts assert that spiraling public debt growth will force central banks to monetize the government debt and that this action will assure worsening inflation. Others argue that central banks will choose to pursue policies of high inflation in order to chip away at the debt burden. In fact, deflation, not inflation, is the danger during the next several years in the United States and most of the world’s advanced economies. Moreover, the fears of inflation are based on flawed logic and contrary to the historical record. In the United States and many other developed countries, as in Japan in the 1990s, the macrofinancial circumstances that are presently causing the continuing, large deficits will also keep the economy unusually weak and disinflationary even as monetary policy remains accommodative. Deflation has already been a problem in Japan for over a decade, and it is not far away in the United States, where inflation, measured using the core CPI, was well below 1% and falling in the latest six months…

Could we see a surge in inflation a decade down the road? Perhaps, but it will not be because government debt caused it or the government stealthily engineered it. The biggest inflation threat will be the effect of a secular revival of rapid demand growth on scarce resources. In all probability, the end of the contained depression will bring an era of private sector balance sheet revival, involving not only robust growth, strong tax revenues, and shrinking public debt but also strong investment, which will lead to productivity gains. Those productivity advances, along with deflationary expectations ingrained during the contained depression, will tend to offset the inflationary pressures of rising resource prices. Most likely, deflationary conditions will give way not to galloping price increases but to moderate inflation.

Because Japan is roughly a decade ahead of us in age structure, it should provide us with a glimpse of the outcome described in that last paragraph in the decades ahead.

And the “intersectoral balances” folks, who were among the only economists to see the crisis coming, argue that federal government deficits have long fallen short of where they needed to be to accomodate the demands of the private sector. Consider this now classic 2003 brief from Randy Wray (emphasis added):

Partially due to budget-balancing agreements, partially due to large increases of Social Security taxes in the 1980s, and partially due to a long-term trend to devolve spending responsibility to the states, the federal budget has become excessively biased to run surpluses at moderate rates of economic growth. These surpluses, in turn, require that the nongovernment sector taken as a whole (including households, firms, and the foreign sector) must run deficits. Indeed, the record budget surpluses achieved during the Clinton years were matched by unprecedented domestic private sector deficits—that reached above 6% of GDP.This leads to the second headwind. The US private sector has been spending more than its income every year since 1996. The long-term legacy is record indebtedness that burdens households and firms. As is widely recognized, firms have already cut back spending as they try to work off some of this debt; short-term tax incentives will not induce firms to undertake new projects given idle capacity and heavy indebtedness. American households are widely given credit for the recovery (albeit, an anemic one) as they have continued to borrow and spend. However, no one doubts that consumption is running out of steam. No “revenue neutral” tax cut plan is going to reduce the burden on households and encourage continued growth of consumption…

[D]evolution has placed more responsibilities on state budgets. This is undesirable for two reasons. First, state taxes are regressive (highly so in some cases), placing the heaviest burden on those least able to pay. More importantly, states must act procyclically, increasing spending in a boom (fueling the boom) while slashing spending and raising taxes in a slump (there is little doubt that states helped to turn the early 1990s recession into a “double dip”). It is time for the federal government to increase grants to states, especially on a counter-cyclical basis. Only the federal government can lean against the wind, cutting taxes and increasing spending in a recession. 

Finally, the US trade deficit has trended upward over the past two decades. Unlike many economists, we do not view this with alarm. In our view, the trade deficit results mostly from insufficient demand in the export surplus nations, and a trade deficit allows American consumers to enjoy real benefits (after all, exports are a cost and imports are a benefit). At the same time, however, we recognize that all else equal, a trade deficit reduces American demand for domestic output. Given a balance of payments deficit equal to about 4% of GDP, the US government sector must run a deficit of 4% of GDP simply to allow our private sector to balance its own budget (with spending equal to after-tax income). Hence, all else equal, the federal budget should be biased toward a deficit—not a surplus—at moderate rates of economic growth. The appropriate structural adjustment is on the order of 6-7% of GDP( $600-700 billion).

As we’ve always been careful to point out, domestic monetary policy and trade deficits can contribute to inflation via tradable goods prices — logically, that’s the only way that ”stagflation” can occur (stubbornly refusing to lower tax rates on corporate profits earned abroad — much less raising them! – might add marginally to those pressures, but their more important effect is to limit domestic investment by U.S. multi-nationals). 

But with household consumption on a lower trajectory in the U.S., we should be so lucky as to have to worry about importing inflation. Referring again to our interview with Diane Macunovich, without the explosion of household formation that was led by baby boomers from the late 1950s to 1980 — in many countries – we just don’t see a repeat of 1960s and 70s style inflation as a remotely possible outcome.

Wray’s missive also brings up an important political consideration. Instead of continuing to laud the Clinton-Dole-Gingrich era surpluses, Democrats and others on the left should read and re-read the Wray piece, in which he endorsed the deficits likely to result from the Bush tax cuts (if not the particular types of cuts themselves). The longer they hew to the ‘fiscal discipline’ dogma of the New Democratic Leadership Council and the old Bentsen-Rubin-Summers axis of Clinton Treasury Secretaries, the more likely they are to be turned out on their ears in 2010 and 2012.

Finally, for those who still need confirmation that fiscal policy should remain loose until the private sector is in better balance (ideally via well designed spending and tax cuts, for a decade or more if that’s what it takes), consider these recent comments from former Fed chair Alan Greenspan:

Greenspan, in a telephone conversation…said his position is that all the expiring Bush tax cuts should end, for middle-class and high- income families alike.

Ending the cuts “probably will” slow growth, Greenspan, 84, said in the TV interview. The risk posed by inaction on the deficit is greater, he said.

“Unless we start to come to grips with this long-term outlook, we are going to have major problems,” said Greenspan, who led the U.S. central bank from 1987 to 2006. “I think we misunderstand the momentum of this deficit going forward.”

Greenspan said reducing the deficit is “going to be far more difficult than anybody imagines” after “a decade of major increases in federal spending and major tax cuts.”

Ask yourself how many things the man has been wrong about in the past two decades, and then ask yourself if he’s likely to be right about this issue. We don’t need to, but if we did, our answer would be a resounding “No.”

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a Pennsylvania registered investment advisor that offers discretionary investment management to individuals and institutions. This publication is for informational, educational, and entertainment purposes only. It is not an offer to sell or a solicitation to buy securities, or to engage in any investment strategy. Some clients of the firm own TIP, TLT, nominal Treasuries, and Treasury Inflation Indexed Securities (also known by the acronym TIIS or “TIPS”).