Sheer weight of the balance sheet may be undone

Oldie, but maybe relevant now.  I had no idea what a genius Tversky was, although I once met Kahneman, who seemed that way too. I saw from dashboard some guy had looked this up. Oh, yeah, I wrote this.


Michael Lewis’s The Undoing Project is a great book with a lot of keeper passages.  Here is one, describing Amos Tversky’s ability to relate intelligently to a wide range of audiences:

Amos seemed able to walk into any problem, however alien to him, and make the people dealing with it feel as if he grasped its essence better than they did.  The University of Illinois flew him to a conference about metaphorical thinking, for instance, only to have Amos argue that a metaphor was actually a substitute for thinking.  “Because metaphors are vivid and memorable, and because they are not readily subjected to critical analysis, they can have considerable impact on human judgment even when they are inappropriate, useless, or misleading,” said Amos.  “They replace genuine uncertainty about the world with semantic ambiguity. A metaphor is a cover-up.”

I do not know if Tversky demonstrated those claims, but I don’t need any convincing, given our experience in macro over the past decade.  At least half the reason people were so wrong about the Fed – in one direction and for an entire decade in a row – seems to be that they fell for metaphors.  This is apocryphal:

The Fed printed $3 trillion of liquidity that had to go somewhere. It ended up rigging every asset price on the planet to the ceiling.  Meanwhile, the Fed pushed interest rates down to an unnatural level, which created a tremendous stretch for yield and pushed investors out the risk curve.  This set up a house of cards, which was bound to collapse as soon as the Fed lifted off zero and pulled away the punch bowl, because as that point the economy would have to stand on its own two feet.

I was reminded of the Lewis passage and of how damaging metaphors have been in this episode, when I turned on the computer this AM and saw this from Bloomberg (screen shot):


There are a lot of metaphors there. By far, the most damaging to the understanding of a very simple point is the image of the Fed’s balance sheet as a weight sitting on the long end of the yield curve.

Let’s skip the metaphor and think of what actually happened in the Treasury market from a supply and demand perspective after the crisis.  Using very round numbers, the Treasuring issued $5 trillion of government securities and the Fed bought $3 trillion. So there was a net supply of $2 trillion, which was actually fairly “heavy” by historical standards, even when normalized to the size of the economy.

Larry Summers worked with Greenwood, Hanson and Rudolph to do the numbers more precisely, and here is his summary of that work presented on his own blog.

On the issue of QE Greenwood, Hanson, Rudolph and I show that the contrary to much of the discussion during the QE period the stock of longer term public debt that the market has to absorb went up not down.  The amount of longer term Federal debt that markets have to absorb is now as high as it has been in the last 50 years and long rates are extraordinarily low, as are term spreads.  This calls into question the idea that price pressures caused by changing relative supplies are likely to have large impacts at times like the present when markets are functioning.

Clearly, bond yields did not fall and remain low during the crisis simply because the public sector manipulated duration supply. If that force had been dominant, then bond yields would have gone up.  There is also the issue of rates signaling, forgive the metaphor, etc. etc. etc.

I am not going to get into the QE debate yet again.  But the point is that these issues are best considered directly, not through metaphor. In my opinion, Tversky is absolutely right about metaphors, and with high practical importance. So the next time you hear somebody trying to snow you with metaphors, you will be forearmed!

With the balance sheet set possibly to be reduced, I guess we have to have an opinion on what effect that might have on bond yields. Beyond the rates signaling and short-term announcement effects, I would not expect much enduring from balance sheet policy per se.  If yields get to the wrong level, then real-economy forces will bring them back. (I realize that would be true as well if QE were a potent policy tool.) But there is not much value in pounding the table emphasizing that take, given that bonds still look like seem to offer return-free risk here.