Tag: interest rates

Bubbles, Uncertainty, and QE2

Within the Federal Reserve System, there is a tug of war over QE2 (2nd Quantitative Easing).  Some, mostly outside the system, are calling for $1 trillion-plus purchases of long-term bonds.  Within the Fed, there is little taste for purchases that large. I expect a compromise, with an initial purchase perhaps as low as $100 billion.

There is widespread doubt as to the efficacy of further purchases of long-term bonds. They will supply additional liquidity, but liquidity isn’t what is needed. Businesses and banks are suffering from fear and uncertainty: new taxes, new regulations, new mandates, and, for financial services, the uncertainty of the Dodd-Frank banking bill. 

Lower interest rates on long-term bonds will do nothing to diminish fear and uncertainty. Instead, QE2 will further inflate the bond bubble and the commodities bubbles.

Fed’s QEII Offers More Risk Than Reward

As the Federal Reserve Federal Open Market Committee (FOMC) meets today, it is widely expected that the Fed will announce a new round of quantitative easing (QE).  The first round began in March 2009, as the Fed started large-scale purchases of Fannie and Freddie debt and MBS.  The next round is expected to focus on purchases of long-dated US Treasuries.

The objective of QEII would be to reduce long-term interest rates, with the belief that such a reduction would spur investment and consumption, thus increasing employment.   Estimated impacts on rates range from zero to 80 basis points (80/100s of one percent).  

Given the large excess reserves in the banking system, it is likely that much of the monetary stimulus provided by QEII will simply be added to bank reserves, which would correspondingly have little to no impact on either lending or interest rates.  So its likely that we will get very little bang out of QEII.

Even if QEII did lower rates as much as some Fed leaders claim, the impact would still be relatively small, under one percent.  Given that mortgage rates have already fallen by that much over the last six months without changing the direction of the housing market, it is hard to see even a 1% decline in rates moving the economy.  Quite simply, the major problem facing the economy today is not high interest rates.

The real impact, and the greatest risk, of QEII is that it changes expectations of inflation.  It seems pretty clear that the Fed wants higher inflation than we have now.  QEII sends the signal that the Fed will do everything possible to create that additional inflation.  QEII also runs the real risk that the Fed ends up “monetizing the debt” - both reducing the political pressure to address our fiscal imbalances as well as undermining the dollar.  I see these risks as easily outweighing what little bump one might get from a few basis points decline in long-term interest rates.

Prof. Krugman Is Wrong, Again

Prof. Paul Krugman asserts in his New York Times column of May 31st that “Both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea – not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts.”

While Prof. Krugman and most other fiscalists believe this to be self-evident, it is not.  Indeed, this fiscalist dogma fails to withstand the indignity of empirical verification.  Prof. Paul Krugman’s formulation fails to mention the state of confidence.  This is an important oversight.  As Keynes himself put it: “The state of confidence, as they term it, is a matter to which practical men pay the closest and most anxious attention.”

By ignoring the confidence factor, economic theory can lead to wildly incorrect conclusions and misguided policies.  Just consider naive Keynesian fiscal theory – the type presented (as Prof. Krugman notes) in textbooks and embraced by most policymakers and the general public.  According to Keynesian theory, an expansionary fiscal policy (an increase in government spending and/or a decrease in taxes) stimulates the economy, at least for a year or two after the fiscal stimulus.  To put the brakes on the economy, Keynesians counsel a fiscal contraction.

A positive fiscal multiplier is the keystone for Keynesian fiscal theory because it is through the multiplier that changes in the budget balance are transmitted to the economy.  With a positive multiplier, there is a positive relationship between changes in the fiscal deficit and economic growth: larger deficits stimulate growth and smaller ones slow things down.

So much for theory.  What about the real world?  Suppose a country has a very large budget deficit.  As a result, market participants might be worried that a further loosening of fiscal conditions would result in more inflation, higher risk premiums and much higher interest rates.  In such a situation, the fiscal multipliers may be negative.  Fiscal expansion would then dampen economic activity and a fiscal contraction would increase economic activity.  These results would be just the opposite of those predicted by naive Keynesian fiscal theory.

The possibility of a negative fiscal multiplier rests on the central role played by confidence and expectations about the course of future policy.  If, for example, a country with a very large budget deficit and high level of debt (estimated U.S. deficit and debt levels as a percentage of GDP for 2010 are 10.3% and 63.2%, respectively) makes a credible commitment to significantly reduce the deficit, a confidence shock will ensue and the economy will boom, as inflation expectations, risk premiums and long-term interest rates decline.

There have been many cases in which negative fiscal multipliers have been observed.  The Danish fiscal squeeze of 1983-86 and the Irish stabilization of 1987-89 are notable.  The fiscal deficits that preceded the Danish and Irish fiscal squeezes were clearly unsustainable, and risk premiums and interest rates were extremely high.  Confidence shocks accompanied the fiscal squeezes, and with negative multipliers in play, the Danish and Irish economies took off.  (Evidence from the U.S. is presented in an article by Professors Jason E. Taylor and Richard K. Vedder which appears in the current May/June 2010 issue of the Cato Policy Report.)

Margaret Thatcher also made a dash for confidence and growth via a fiscal squeeze.  To restart the economy in 1981, Thatcher instituted a fierce attack on the British deficit, coupled with an expansionary monetary policy.  Her moves were immediately condemned by 364 distinguished economists.  In a letter to the Times of London, they wrote a knee-jerk Keynesian (Prof. Krugman-type) response: “Present policies will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.”  Thatcher was quickly vindicated.  No sooner had the 364 affixed their signatures than the economy boomed.  People had confidence in Britain again, and Thatcher was able to introduce a long series of deep free-market reforms.

While Prof. Krugman’s authority is weighty, his arguments and evidence are slender.

Do Earmarks Crowd Out Local Private Investment?

The extent to which government spending either complements or crowds out private investment has long been one of the most heated debates in economics (and politics).  Generally economic theorists posit that an increase in government spending drives up interest rates, which increases the cost of private investment, accordingly reducing such investment.  Most macroeconomic models are build on this relationship. 

In an interesting new working paper, a trio of economists attack the question from a different angle.  They measure the impact of increased earmarks on the local economy receiving those earmarks, and compare the impact to areas not receiving the increased earmarks, which allows them to control for the overall macroeconomic environment.  Their finding: even in a setting where government spending is “free” to the recipients (but not free to the rest of us), such spending reduces private investment. 

More specifically, the authors examine what happens to a state when one of its senators becomes a chair of a powerful committee.  First, the obvious, upon taking a power chairmanship, the value of earmarks increase almost 50%.  This results in roughly a $200 million annual increase to the state.  But the authors find this is not simply a transfer from the rest of the country to the state, it also depresses private capital investment and R&D spending in the state.  On average, once a state has a senator obtain a powerful chairmanship, state level private investment in capital expenditures decreases $39 million annually and state private R&D decreases $34 million annually. 

For states seeking to get your senator into a powerful chairmanship:  be careful of what you wish for.  There’s no free lunch, even when someone else is paying.

Fannie, Freddie, Peter, and Barney

Last week, after Rep. Barney Frank (D-MA) said that holders of Fannie Mae and Freddie Mac’s debt shouldn’t be expected to be treated the same as holders of U.S. government debt, the U.S. Treasury took the “unusual” step of reiterating its commitment to back Fannie and Freddie’s debt.

If ever there was case against allowing a few hundred men and women to micromanage the economy, this is it.

Fannie and Freddie, which are under government control, are being used to help prop up the ailing housing market. If investors think there’s a chance Uncle Sam won’t back the mortgage giants’ debt, mortgage interest rates could rise and demand for housing dampen. Therefore, Frank’s comments caused a bit of a stir. However, with the government bailing out anything that walks or crawls, investors apparently weren’t too concerned with Frank’s comments as the spread between Treasury and Fannie bonds barely budged.

As I noted a couple weeks ago, the Treasury is in no hurry to add Fannie and Freddie’s debt and mortgage-backed securities to the budget ($1.6 trillion and $5 trillion respectively). Congress certainly isn’t interested in raising the debt ceiling to make room. And as Arnold Kling points out, putting Fannie and Freddie on the government’s books would actually force the government to do something about the doddering duo.

All of which points to what an unfunny joke budgeting is in Washington. Take a look at what current OMB director Peter Orszag had to say about the issue when he was head of the Congressional Budget Office:

Given the steps announced by the Treasury Department and the Federal Housing Finance Agency on September 7, it is CBO’s view that the operations of Fannie Mae and Freddie Mac should be directly incorporated into the federal budget. The GSEs’ revenue would be treated as federal revenue and their expenditures as federal outlays, with appropriate adjustments for the manner in which credit transactions (like a mortgage guarantee) are reflected in the federal budget.

Note that Orszag wrote that statement less than two years ago. And since then, the bond between the government and the mortgage giants has only gotten tighter.

The same people that say Fannie and Freddie shouldn’t be on the government’s books are often the same people who once dismissed concerns that the two companies were headed toward financial ruin. In 2002, Orszag co-authored a paper at Fannie’s behest that concluded that “the probability of default by the GSEs is extremely small.”

Another one of those persons, Congressman Frank, has his fingerprints all over the housing meltdown. In 2003, a defiant Frank stated that “These two entities – Fannie Mae and Freddie Mac – are not facing any kind of financial crisis.” Frank couldn’t have been more wrong. Yet there he remains perched on his House Committee on Financial Services chairman’s seat, his every utterance so important that they can move interest rates.

Wednesday Links

  • Even though the government is running massive deficits, interest rates and inflation are low. So, what’s the problem?

Predictions for 2010

I was just listening to the December CatoAudio interview with Tom Palmer and Ian Vasquez about the fall of the Soviet empire 20 years ago, and Tom mentioned that even as late as October 7, 1989, when the East German government held a gala celebration of its 40th year in power, no one anticipated that within a month the Wall would open and communism would come to an abrupt end in eastern Europe.

And then I looked at the predictions of various scholars and pundits at Politico’s Arena one year ago today and noticed how wrong most of them were – Terry McAuliffe would be elected governor of Virginia, Rod Blagojevich would still be governor in April, Iran would test a nuclear weapon, several Republican members of Congress would switch to the Democratic Party (!), Justice Stevens would retire. No one predicted the surge of small-government, anti-spending sentiment, which was arguably the top political story of 2009.

And then, looking up who said “Nobody knows anything” (screenwriter William Goldman, about Hollywood), I stumbled on this blog post from October 2008:

I pulled from my desk drawer a copy of the Wall Street Journal from Wednesday, May 23, 2007.

It was not a particularly notable day.  The bull market was in force, and the Dow was hitting new highs … even though gasoline prices were at record levels.  But here at Cabot we had been noting a growing divergence in the market; both the NYSE Advance-Decline Line and the Nasdaq had failed to confirm the Dow’s high.  Also, we detected a high level of optimism among both investors and the general media.  So I saved The Wall Street Journal, in part because of the lead article that announced, “Why Market Optimists Say This Bull Has Legs.”

The subhead of the article followed with, “They See Decade of Gain Fed by Global Growth; Skeptics Cite Big Doubts.”…

So I reread the article and what did I find?  Fundamental talk about global growth, low interest rates and a technology revolution that would boost productivity.  [One bull] even had the courage to utter the phrase that makes an experienced investor quail, ” … it really is different this time.”

Also given ink were the detractors, who claimed that reversion to the mean was inevitable, that low interest rates couldn’t last, and that the weak dollar and above-average P/E ratios would eventually pull the market down.

But here’s what I found interesting (in hindsight):  Not once in the entire article did anyone mention credit!!!

Today, we know from our rearview mirror that credit was the culprit of a decline that has crushed the global financial system.  But just 17 months ago, a reporter looking for reasons the bull might not last found no one mentioning credit!

All of which is to explain why you’re not going to find any predictions for 2010 in this post.

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