ARMs as Automatic Stabilizers

An argument often heard for keeping Fannie Mae and Freddie Mac, or some sort of subsidy for mortgages, is the desire to keep the 30 year fixed rate mortgage “affordable.” The 30 year fixed certainly has some merits - which borrowers should be willing to pay for - but it also has the downside of reducing the impact of monetary policy in stabilizing the economy.

Generally interest rates go down in a recession and up in an expansion.  Part of this is the reaction of the Federal Reserve, which tends to cut rates in a recession, but part is also the fact that the demand for credit also declines in a recession and increases in an expansion.

If borrowers moved to adjustable rate mortgages, then in recessions they would likely see a reduction in their mortgage rate, resulting in a reduction in their monthly payment, which would increase their disposable income, which itself should have some positive impact on consumption, helping to stabilize a weak economy.

The reverse would work in an expansion.  If the economy became over-heated, interest rates would likely go up, pushing up monthly payments, resulting in reductions in income and consumption.  While of course this would be unpleasant for the borrower, it would have the benefit of moderating a booming economy, reducing the likelihood of inflation and the occurrence of bubbles.

The latter effect would also increase the degree to which consumers care about inflation and demand price stability from the central bank.  Normally, borrowers have an incentive to favor inflation, as it reduces the real value of their debt.  If however, inflation resulted in an increase in their mortgage rate, their preference could switch toward price stability, which would in the long run be better for growth and the overall economy.

While I do not expect the above to settle the debate over the role of the 30 year fixed rate mortgage, we, as a society, should openly and loudly debate its costs and benefits before we simply assume it needs to be subsidized.