Bill Gross
Bill Gross.

In the wake of Bill Gross' shock departure, Paul Krugman has been hammering on an important point, which is that PIMCO really started hitting the rocks when Bill Gross made a wrong call about interest rates in 2011.

Paul Krugman has written four posts on the topic ( here, here, here, and here).

So what's it all about?

Well here's the quick and dirty version.

In early 2011, Bill Gross completely exited the Treasury market on the premise that interest rates were going to surge and hit bonds.

He thought interest rates were going to surge because the Fed was ending QE2 in the summer of 2011. In a note written to investors in March 2011, he asked: Who will buy Treasuries when the Fed doesn't?

The thinking was that the federal government was running gigantic, trillion-dollar deficits at the time that nobody wanted and that it was only the Fed buying debt, holding our interest rates down.

That sounded compelling but was actually pretty flimsy, and even at the time people were criticizing the thinking.

Krugman was one of those people, arguing that interest rates weren't a function of how much debt the US was offering, but rather about US growth and inflation prospects. And because we were digging ourselves out of a gigantic economic hole at the time, there was no chance of a pickup in inflation.

So Gross was using a flawed economic model (as were the deficit hawks who insisted that the US had to get its spending down to avoid a Greece-like bond spiral).

When QE2 ended, interest rates didn't rise — they actually fell, perhaps because the markets interpreted the end of Fed easing as a reason to bet against rising inflation or growth.

This was THE core economic debate of the post-crisis years. The economists like Krugman, who relied on traditional models, correctly surmised that interest rates would not surge and that the debt would not be a problem.

Folks like Bill Gross (and Republican politicians) thought the Fed was distorting the market and keeping interest rates from surging, and that turned out to be wrong.

And that led to a period of underperformance for PIMCO and the start of the turmoil that saw significant outflows and ultimately the departure of Mohamed El-Erian and then Gross.

These debates mostly aren't talked about now, but as stated above, this was really the whole story back in the day. And it ended up costing Gross his role in the company he created.