Topic: Finance, Banking & Monetary Policy

Imaginary Squabbles Part 5: Comparing Krugman’s 2005 Housing Bubble Forecasts to Mine

New York Times columnist Paul Krugman has recycled another phony argument about something I wrote many years ago. 

He begins by citing Matt O’Brien who found that Fed governor Janet Yellen in October 2005 was predicting there would be no great impact on the economy “were the house-price bubble to deflate.” O’Brien concludes that, “Back in 2005, she didn’t appreciate how much shadow banks relied on AAA-rated mortgage-backed-securities (MBS) as collateral to fund their day-to-day operations—or how much even this supposedly high-quality collateral could go bust if housing did.” But that is “What Janet Yellen and Everyone Else Got Wrong,” as Krugman’s column is rightly titiled. Nobody in 2005 grasped what a precarious house-of-cards was being built, worldwide, on U.S. mortgage-backed securities. 

O’Brien found another quote suggesting Yellen did get it right by December 2007. Yet the recession had already started by then, and blogger Bill McBride and others were worrying that rising unemployment would cause mass foreclosures (not the other way around).

“We had a monstrous housing bubble,” writes Krugman, “and Janet Yellen recognized it in real time [December 2007]…. It’s important to notice that just being willing to see the obvious here puts Janet Yellen way ahead of a lot of people who still presume to give us advice on the economy.”   

He links to a 2008 list of 28 people who were supposedly way behind Yellen in “being willing to see” that house prices had fallen 21.6 percent by December 2007, even though nearly all of those 28 references were from 2003–2005. My name is at the top of that list, of course. But why am I on it while Krugman and Yellen are not?

The “Unofficial List of Pundits/Experts Who Were Wrong on the Housing Bubble,” was compiled by a finance lawyer who blogs as “Economics of Contempt.” He worked as a legislative aide to a House Democrat and dealt with derivatives at Lehman Brothers. The list of 28 could find no investment bankers who got it wrong, even at Lehman or Bear Stearns, but it did find a lot of conservatives and libertartians.   

Obama’s Housing Speech: The Good, The Bad, & The Ugly

Yesterday, President Obama went to what was perhaps ground-zero of the housing crisis: Phoenix. He laid out his vision for the role of housing in building a middle class, as well as his solutions for avoiding bubbles.    

On the rhetorical side, the president certainly laid out some principles that anyone would be hard-pressed to disagree with. For instance, he characterized the business mode of Fannie Mae and Freddie Mac as “heads we win, tails you lose”–which of course it was. The president was correct in calling it “wrong.”  If only then-Senator Obama had aided the efforts to reform Fannie and Freddie by Senator Richard Shelby and others, perhaps this mess could have been avoided. But, hey–better late than never.  

The president is also correct in highlighting the issue of local barriers that increase the cost of housing. Both Cato’s Randy O’Toole and I have written regularly on this topic. You don’t get bubbles without supply constraints. But then every president since Reagan, at least, has pointed to this problem and yet it has only gotten worse. If the president has a substantial plan to bring down regulatory barriers in places like California, then I would love to see it.

Perhaps most importantly, the president recognized that what we had was a housing bubble, and the solution isn’t to “just re-inflate” it. As the president urged, we must “turn the page on the bubble-and-bust mentality” behind the housing crisis. That was the good, and again I applaud the president for recognizing those facts.  

Unfortunately, what details we have of his vision are not exactly consistent with these facts–which are bad and ugly. The president wants “no more leaving taxpayers on the hook for irresponsibility or bad decisions,” but then he implies that government should continue to stand behind risk in the housing market. The primary purpose of FHA, which the president commends, is to allow lenders to pass along the costs of their mistakes to the taxpayer.  

Mr. President, there is only one way to take the taxpayer off the hook:  get the government out of the mortgage market.  Anything short of that will continue to undermine the incentive for lenders to make responsible loans.  

What Is Syria’s Iranian Credit Line Worth?

Last week, the press was filled with reportage about Tehran throwing a lifeline – actually a credit line of $3.6 billion  – to the Syrian regime.

The announcement of this Iranian lifeline should have changed the economic expectations of Syrians in the throes of what has morphed into a bloody civil war. Indeed, if it materializes, the $3.6 billion credit line should allow Damascus to conserve its dwindling supply of foreign exchange. This development should have thrown a positive expectation shock into the market for the Syrian pound.

So, did economic expectations receive a positive boost from the announcement of Tehran’s lifeline? Let’s go back to May 27th. That’s when the tentative credit line agreement was announced. A mini event study shows that the initial agreement had no material impact on expectations, as objectively measured by the Syrian pound/U.S. dollar black-market exchange rate. Indeed, the SYP/USD exchange rate was unmoved by the tentative agreement (see the accompanying table).

The next event in this credit line story occurred on July 30th, when it was announced that the May agreement had been finalized and signed on July 29th. Again, expectations and the SYP/USD exchange rate remained unmoved (see the accompanying table):

What, then, can we say about the Tehran-Damascus deal? Well, objective data – namely market prices – tell us that the widely-reported event had no material effect on Syrians’ economic expectations. Accordingly, the implied inflation rate for Syria remained unmoved. Using these objective black-market exchange-rate data, I estimate that Syria is currently experiencing an annual inflation rate of 190.7%.

In short, Syrians viewed the deal as irrelevant. They think that either Iranians won’t deliver on the promised credit line, or that if they do, it will not change the situation on the ground.

I often tell my students to be mindful of the late Prof. Armen Alchian’s “95% rule”: Ninety-five percent of what you read that passes for finance and economics is either wrong or irrelevant. For the time being, it appears that Syria’s Iranian credit line falls under the latter category.

I have established a page to track current black-market exchange-rate and implied inflation data for the Syrian pound, as well as for troubled currencies in Iran, Argentina, North Korea, and Venezuela. For more, see: The Troubled Currencies Project.

Entrepreneurs and Capital Gains Taxes

I testified to the Senate Small Business Committee last week about capital gains taxation.

I noted to the committee that reduced capital gains taxes can generate greater financing of young companies by angel investors and venture capitalists. Lower capital gains taxes can also encourage people to become entrepreneurs because the payoff from a successful start-up is improved compared to a wage job. Entrepreneurs put their own money into their ventures and want to maximize the financial returns from their hard work and sacrifice.

The higher capital gains taxes that were recently enacted risk killing off future Apples and Amazons, which we will need to power tomorrow’s economic growth. Congress raised the top federal tax rate on long-term capital gains from 15 percent to 23.8 percent. When state-level taxes are included, the average top U.S. tax rate on long-term capital gains is 27.9 percent.

U.S. policymakers need to understand that capital gains are different than ordinary income, which is why most nations have top capital gains tax rates that are much lower than their top rates on ordinary income. The U.S. capital gains tax rate is much higher than the average rate of just 16.4 percent in the 34 nations of the Organization for Economic Cooperation and Development (OECD).

Long-term capital gains should be subject to low or zero tax rates. Hopefully, federal policymakers will reconsider capital gains tax policy in coming months and reduce our tax rate to at least the average rate of our OECD trading partners. A lower capital gains tax rate would boost innovation, spur entrepreneurship, and help America regain its competitive edge.

See my recent report for a full discussion.

Egypt’s Vanishing Currency Black Markets

Despite escalating tensions between Egypt’s new military-backed government and supporters of ousted president Mohammed Morsi, there is at least one positive development coming out of the Land of the Nile. Yes, at long last, some semblance of stability appears to be returning to Egypt’s economy.

After the ouster of President Hosni Mubarak in 2011, the Egyptian economy took a turn for the worse. In particular, the Egyptian pound began to slide shortly after Morsi and his Muslim Brotherhood-backed government took power, sparking the development of a black market for foreign currency. The accompanying chart tells the tale: the official and black-market EGP/USD exchange rates began to diverge sharply in late 2012. In recent weeks, however, they have converged.

Recent currency auctions by the central bank, coupled with improved expectations about the country’s economic prospects, have begun to buoy the struggling pound. Indeed, the black-market exchange rate is now 7.13 EGP/USD, very close to the official rate of 7.00 EGP/USD. So, with Morsi, the black market appeared, and with the military’s re-entry, the black market has all but vanished.

The Egyptian stock market is echoing the confident sentiments displayed by the foreign exchange markets (see the accompanying chart). But, it remains to be seen if this newfound confidence in the Egyptian economy will be sustained.

Wall Street Journal Condemns OECD Proposal to Increase Business Fiscal Burdens with Global Tax Cartel

What’s the biggest fiscal problem facing the developed world?

To an objective observer, the answer is a rising burden of government spending, which is caused by poorly designed entitlement programs, growing levels of dependency, and unfavorable demographics. The combination of these factors helps to explain why almost all industrialized nations—as confirmed by BIS, OECD, and IMF data—face a very grim fiscal future.

If lawmakers want to avert widespread Greek-style fiscal chaos and economic suffering, this suggests genuine entitlement reform and other steps to control the growth of the public sector.

But you probably won’t be surprised to learn that politicians instead are concocting new ways of extracting more money from the economy’s productive sector.

They’ve already been busy raising personal income tax rates and increasing value-added tax burdens, but that’s apparently not sufficient for our greedy overlords.

Now they want higher taxes on business. The Organization for Economic Cooperation and Development, for instance, put together a “base erosion and profit shifting” plan at the behest of the high-tax governments that dominate and control the Paris-based bureaucracy.

What is this BEPS plan? In an editorial titled “Global Revenue Grab,” The Wall Street Journal explains that it’s a scheme to raise tax burdens on the business community:

After five years of failing to spur a robust economic recovery through spending and tax hikes, the world’s richest countries have hit upon a new idea that looks a lot like the old: International coordination to raise taxes on business. The Organization for Economic Cooperation and Development on Friday presented its action plan to combat what it calls “base erosion and profit shifting,” or BEPS. This is bureaucratese for not paying as much tax as government wishes you did. The plan bemoans the danger of “double non-taxation,” whatever that is, and even raises the specter of “global tax chaos” if this bogeyman called BEPS isn’t tamed. Don’t be fooled, because this is an attempt to limit corporate global tax competition and take more cash out of the private economy.

The Journal is spot on. This is merely the latest chapter in the OECD’s anti-tax competition crusade. The bureaucracy represents the interests of
high-tax governments that are seeking to impose higher tax burdens—a goal that will be easier to achieve if they can restrict the ability of taxpayers to benefit from better tax policy in other jurisdictions.

More specifically, the OECD basically wants a radical shift in international tax rules so that multinational companies are forced to declare more income in high-tax nations even though those firms have wisely structured their operations so that much of their income is earned in low-tax jurisdictions.

A Big, Tiny Deal on Student Loans

After a bit of a false start last week, it sounds again like the Senate is on the brink of a bipartisan compromise that will link rates on federal student loans to overall interest rates. Given all the hubbub that’s surrounded the loans, that’s big news. Given the actual change that would take place, it’s tiny.

Based on reports so far, the plan seems to be to eventually peg all undergraduate loans – both the officially “subsidized” and “unsubsidized” – to 10-year Treasury bill interest rates, adding 2.05 percentage points. Today, that would make the interest rate 4.57 percent. However, it appears that the compromise would put rates at 3.85 percent this fall. That’s no doubt a sweetener to appease student interest groups, whose goal is to get the cheapest loans possible regardless of the rest of the economy, and who don’t think a deal pegging student loans to T-bills is so hot.

To be fair, the deal isn’t hot. It’s barely room temperature. But that’s because it still gives away far too much, not too little. Taxpayer-backed loans that go to almost anyone have been a sweet-sounding disaster, encouraging people to consume education they aren’t willing or able to complete; prodding people who are college-ready to demand things that have little or nothing to do with education; and fueling rampant price inflation throughout the system. And, like last week’s abortive deal, this one appears to eliminate the different rates for the “subsidized” loans – those geared to truly low-income students – and the “unsubsidized” loans that have no income cap. In other words, the student aid system that is already heavily skewed toward the better-off seems likely to become a bit more so.

If this compromise eventually gets signed by the president, it will likely be hailed as a big, bipartisan deal. And maybe politically it would be. But as policy? It would barely register.