Bill Gross: Deficit Hawk, Bond Vigilante

By Edward Harrison

• American politicians and citizens alike have no clear vision of the costs of a seemingly perpetual trillion-dollar annual deficit.
• Policy stimulus is focused on maintaining current consumption as opposed to making the United States more competitive in the global marketplace.
• Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the global valuation of dollar denominated assets.

These are the intro bullet points in Bill Gross’ latest monthly outlook, aptly titled "Off With Our Heads". Gross then references a brilliant quote about the mating habits of mantises in which the unassuming male thinks everything is super, with his having a good time and all, only to have his head eaten by the female as he does his business.

Bill Gross has gone from supporter of trillion dollar deficits in June 2008 to deficit hawk, bond vigilante in January 2011. His point: trillion dollar deficits and low bond yields work until they don’t. Just when you think the party is getting into high gear, the bond market vigilantes come in and take the punch bowl away. Claus has written this up asking whether the verdict on US bond yields right now is about the economy or deficits. Clearly Gross is saying low yields are about the (poor) economy. But if the economy grows fast enough, yields will be about the deficits.

He has four broad conclusions:

1. American wages will lag behind CPI and commodity price gains.
2. Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the global valuation of dollar denominated assets.
3. 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.
4. Trillion dollar annual deficits add up, and eventually produce a stock of debt that can become unmanageable.

I have a different take. Let’s look at the expectations theory of interest rates. I wrote "Market discipline for fiscal imprudence and the term structure of interest rates" to cover just this ground. Here’s the point:

long-term interest rates are really a series of short-term rates smashed together. The real reason that the Federal Reserve would lose control over short-term interest rates is because the economy was operating at full capacity and creating inflation which provoked an increase in rates.

Long-term interest rates are based on expectations of future short-term rates, something the Fed controls. If the economy struggles, short rates will stay at permanent zero (PZ) just as they have in Japan. The only reason the Fed is going to raise rates is to forestall inflation. The deficits are largely irrelevant.

Does focusing on deficit reduction reduce deficits? No.

Budget deficits are the result of an ex-post accounting identity. In plain English this means that the deficits are the effect and not the cause.

This deficit fetishism is completely misguided. Government should be focused on the causes of deficit – both structural and cyclical – rather than the deficit itself per se. Again, deficits are the effect and not the cause.

From a structural perspective, in the US, the deficit is caused almost exclusively by defense and non-discretionary spending i.e. military spending and entitlement spending (Medicare, Medicaid, and Social Security). Other discretionary spending is pitifully small compared to these items. In fact, if you were to eliminate all non-defense discretionary spending today, you would still have an enormous budget deficit. And I would add that it will kill aggregate demand in the short-to-medium term. No one wants to touch non-discretionary spending because its politically radioactive to do so. On this score, I agree with David Stockman.

From a cyclical perspective, the deficit is due to a shortfall in aggregate demand. If the economy were close to full employment, tax revenues would automatically increase, and the deficit would drop dramatically.

Regarding deficits, I conclude :

1. Cyclical deficits are just that cyclical. Focusing on deficit reduction as a cause is likely to increase these cyclical deficits as they have in Ireland.
2. Structural deficits are where the proof is in the pudding. There will be great resistance to cutting military or entitlement programs.
3. The foregoing means mandatory bond issuance to ‘fund’ deficits and debt-to-GDP constraints is artificial. These are implicit indications that we fear cronyism and government waste.
4. Deficits matter only to the degree they steal real resources from productive use, creating a lower long-term economic growth rate. This can be surmised from a rapidly rising debt-to-GDP ratio.

So I think notions of the bond market vigilantes get the economics wrong. What bond market vigilantism usually implies is rising inflation, currency depreciation and/or lower long-term economic growth. Think of Great Britain post-World War II with its massive national debt load, for example.

But there is a third risk: political risk. Let’s call this the Ecuador risk factor. Back in 2006, Ecuador President Alfredo Palacio told investors restructuring Ecuador’s external debts was "absolutely necessary" to make yields on Ecuador’s debt lower. He might as well have been saying, "we are going to stiff the foreigners, so run for the hills" because this is how his comments were interpreted. Yields on Ecuador’s debt promptly spiked out of fear of another default. Ecuador had defaulted in 1999 when the Asian financial crisis hit emerging markets in Latin America with contagion. It made a decision to default again in late 2008 at the height of the credit crisis, with new President Rafael Correa calling the external foreign currency debt "immoral and illegitimate".

So, while I am at it here, I should also mention the national solvency canard. Yesterday, Catherine Rampell wrote "Fearing (Another) U.S. Debt Default" about how the US has defaulted on its external debt in the past.

The first time was in 1790, the only episode Professor Reinhart unearthed in which the United States defaulted on its external debt obligations. It also defaulted on its domestic debt obligations then, too.

Then in 1933, in the midst of the Great Depression, the United States had another domestic debt default related to the repayment of gold-based obligations. Additionally, there were two episodes when a spate of American states defaulted on their debts, in 1841-42 (nine states) and 1873-84 (10 states). The havoc wreaked by these state-level defaults is part of the reason that so many states now have constitutional balanced-budget requirements.

Here’s the thing though. The U.S. had a gold standard when these events occurred. The second default wasn’t actually a ‘technical’ default, just a temporary repudiation of the gold tie by suspending convertibility to gold. We live in a fiat currency world now. That word fiat is the key one since the tie to gold was severed in the 1971 ‘default’ – if you want to call it that, even though it wasn’t a technical default.

Countries that have gone bust, Russia, Mexico, and Argentina were borrowing in foreign currency because of interest rate differentials. No sovereign nation which prints and issues debt in its own fiat currency can ever involuntarily be made insolvent.

–Russia, sovereign debt defaults, and fiat currency

Remember quantitative easing? That’s current policy in the U.S.. The Fed could simply buy every Treasury bond it wanted to by creating electronic credits out of thin air.  If the U.S. stopped issuing treasuries, would it go broke? No. If the Treasury were not mandated to issue Treasury bonds by law (remember the artificial constraints I mentioned earlier?),  it could simply credit bank accounts with money to pay its obligations in US dollars.  The real issues on government debt in US dollars are inflation and currency depreciation.

Why do people keep on talking about national solvency like its a real issue? Oh I know: the Ecuador risk factor. With the talk of a government shutdown showdown.

The key here is that it does no good for the Republicans politically to compromise with President Obama. His policies are rightfully seen as failed. The right thing to do politically (but not morally) is to try and strike as much contrast to the President as you can, especially if it makes him look more failed. So that means favouring gridlock and pushing deficit reduction, looking for spending cuts and so on – even if it leads to a government shutdown stare-down as it did under Clinton. Is this the right thing to do?  I don’t think so, if only because it reduces the number of potential positive economic outcomes. But I am speaking now more from a forecasting perspective than one of advocacy.

–A few comments about Tuesday’s election’s impact on the economy

So let’s be clear, the question in the US is about political risk, not of national solvency any more than British National Solvency is in question. That’s why yields in Greece and Ireland are so much higher than they are in the US, the UK or Japan, which have equivalent deficit issues. It has nothing to do with national solvency.

Regarding default, I conclude:

1. The ‘stealth’ default of Dollar depreciation and inflation is always a risk if real resources are malinvested as they are in the US. The US economy is very unbalanced, with a disproportionate share of S&P500 earnings coming from the financial services sector. The US cannot go on artificially propping up its financial services and auto sectors ad infinitum without its taking a toll on long-term growth and bloating debt-to-GDP ratios.
2. Right now, underemployment is 17% as measured by the government’s broadest unemployment measure. With so much idle human capital and with capacity utilization rates in industry still below long-term averages, inflation is not yet the short-term worry. Government should be focused on aiding the economic recalculation that is on-going in order to prevent dead-weight economic loss as people out of work lose skills. If it isn’t, American wages will lag behind CPI and commodity price gains.
3. Any country that issues substantially all of its debt in a currency it creates cannot be forced to default. It can only default because it chooses not to pay for political reasons. Unless the US economy restructures, deficits will continue due to a dearth of aggregate demand. Perpetual trillion dollar deficits will be met by permanent zero rates at the Fed. PZ means attractively low interest rates for as long as possible.
4. The political reasons in the U.S. are a real risk which necessitates higher bond yields. There is a real possibility the U.S. could default.
5. Trillion dollar annual deficits add up, and eventually produce a stock of debt that can become unmanageable.
6. As such, the United States is not a AAA credit in the way Switzerland or Germany is.

Gross ends is piece in a similar fashion.

Above all, remember 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.