The Widowmaker

MOBY BEN, OR, THE WASHINGTON SUPER-WHALE: HEDGE FUNDIES, THE FEDERAL RESERVE, AND BERNANKE-HATRED by DeLong

From my perspective, of course, the hedge fundies' analogy between the London Whale and the Washington Super-Whale is all wrong--the hedge fundies are thinking partial-equilibrium when they should be thinking general equilibrium. CDX IG 9 has a well-defined fundamental value: the payouts should each of the 125 companies go bankrupt times the chance that they will. What Bruno Iksil does does not affect that fundamental value. He can bet, and drive the price, but he cannot change the fundamental.

But the Washington Super-Whale is different.

In a healthy economy, the Ten-Year Treasury Bond does have a well-defined fundamental. When the economy is healthy enough that pricing power reverts to workers and keeping inflation from rising is job #1 for the Federal Reserve, the level of the Federal Funds rate now and in the future is pinned down by the requirement to hit the inflation target. And the fundamental of the Ten-Year Treasury Bond is then the expected value over the bond's lifetime of the future Federal Funds rate plus the appropriate ex ante duration risk premium.

But when the economy is depressed, like now? When market appetite for short-term cash at a zero interest rate is unlimited, like now? When workers have no pricing power, and so wage inflation is subdued, like now? The Federal Reserve is not J.P. Morgan Chase. It is not a highly-leveraged financial institution that must worry about holding too much duration risk. As Glenn Rudebusch once said: "Our business model here at the Fed is simple: (i) print reserve deposits that cost us 0 (OK. 0.25%/yer), (2) invest them in interest-paying bonds that we then hold to maturity, (3) PROFIT!!" And the more quantitative easing the Fed undertakes and the larger is its balance sheet the larger is the amount of money the Federal Reserve makes on its portfolio, without running any risks--as long as the economy remains depressed.

The Federal Reserve, you see, is unlike J.P. Morgan Chase: the Federal Reserve does print money.

Harpooning Ben Bernanke by Krugman

I’d riff on this a bit further. I suspect that the hedge fund guys are relying a lot on historical correlations that worked pretty well for decades: mean reversion of yields, correlations with deficits, etc., most of it pretty much model-free. The trouble is that a once-in-three-generations deleveraging shock makes such correlations useless. Cross-national analogies — i.e., Japan — would have been better, but don’t seem to have been applied. 

What you should be doing is macro analysis, using something like IS-LM — something like what I did here, almost three years ago. (The forecasts have gotten worse since, so the implied long-term rate would be even lower). 

But instead of saying that maybe this macro IS-LM stuff has a point, they’re raging against the man with the beard.