Saturday, June 4, 2011

Krugman's Disastrous Totally Screwed Up Thinking

Paul Krugman has really done it this time. Today, he discusses Treasury TIP Securities and displays an ignorance that a first year bond trader would be fired for having.

The Krug writes:

Thanks to inflation-protected securities, we can look at real rates directly — and here they are:

There was a bump in real rates in the months following Lehman’s failure — that was caused by a flight to liquidity, which meant that only plain-vanilla Treasuries were wanted. But since then real rates have dropped to extraordinarily low levels: less than 1 percent on 10-years, negative on 5-years.
Duh!! Is Krugman really this clueless? Does he really think real rates are negative because the 5 year TIPS has a negative yield (pre-index inflation payout)? This is total amateur night.

Let me explain what is going on here. 

The current 5-year Treasury fixed rate security is yielding 1.6%.  The 5-year inflation adjusted Treasury security is yielding  (pre-index payout) a negative -0.39% .
Krugie thinks this means the real five year rate is negative because the 5-year TIPS is negative.  This is just dumb surface thinking. Since the 5-year fixed rate security is yielding 1.6%, why would anyone buy the TIPS at a negative yield if something else wasn't going on? Krugie doesn't realize a key component of the TIPS is that it acts something like a call option on price inflation. So if I think that one year out, inflation is going to start to seriously heat up and hit double digit rates, than why wouldn't I be willing to pay a negative current rate, if the Treasury security adjusted rate could at some future point climb to 10%?

Alternatively, if for some reason I expect the TIPS inflation adjustment to come in much higher than real inflation and alternative interest rates, I would be willing to buy a negative current yield for a  TIP security.

The point is that there are a number of reasons a TIP security can go negative, none having anything to do with the real interest rate. A negative yield on the TIPS may be a sign that there are many traders willing to pay (by accepting a current negative yield) because they think an inflation adjusted yield is going to be much higher down the road. In fact the more negative the current yield on the TIPS gets, the more it could be a sign of intense expectation of higher price inflation down the road, relative to current interest rates.

Then, there is another important aspect of a TIPS: You will always get back the principle, unlike other inflation hedge investments, such as gold or commodity futures. Thus, in addition to having call type features, it has put type features, which even adds more value (less yield) to this instrument.

 In short, TIPS is a very complex instrument, but it provides no information about the real current yield as the very confused Krugie would have you believe.

The only information Krugie's comment provides is that he is clueless about basic finance and economics. He is clueless about finance because he clearly doesn't understand the call option type feature of TIP securities, which could result in a negative TIPS yield. He is clueless about economics since he should have an immediate gut reaction, if he understood basic economics, that some other factor must be in play if yields are negative. No one  yield is going to put money into an investment with a negative real yield, unless something else is going on. It is utterly amazing that the Kurg doesn't get this. If he doesn't get this basic stuff it is no wonder that he doesn't get more complex stuff like Austrian economics.

(Note to see a 5-year TIPS rate set at auction at a negative yield see the recent April 29, 2011 auction.)


  1. This blog, or something like it, should be in the WSJ. We need to start exposing this man's ignorance. It is a travesty that he is accepted as a respected economist-- he is a political hack at best.

  2. This blog is truly excellent. My new favorite. Always up to date, always interesting.

  3. It's sickening how some people (the elite) still promote this moron as a legitimate economist. His lack of understanding of basic concepts that any 12 year old (at least one who had a cursory knowledge of Austrian economics, or had read Hazlitt) is embarrassing.

  4. "There was a bump in real rates in the months following Lehman’s failure — that was caused by a flight to liquidity, which meant that only plain-vanilla Treasuries were wanted."

    These may be really basic questions: Are plain-vanilla treasuries really that much better for liquidity than TIPS? If not, wouldn't yield decrease when demand for liquid assets increased?

  5. I liked Peter Schiff's comment once about Krugman: If Peter ever gets the Nobel Prize in Econ, he would only accept it if Krugman returned his.

  6. Real interest rates can be negative. If the rate of inflation is greater than the nominal interest rate, this can easily happen. It's not an anomaly - its called deflation. However, NOMINAL interest rates are bounded by 0. So this blog entry is completely off-target in its criticism of Krugman. You shoud re-evaluate your own credentials.