Topic: Finance, Banking & Monetary Policy

A Plug for Financial Fiasco

The distinguished Harvard economist Richard N. Cooper, former president of the Federal Reserve Bank of Boston, praises Johan Norberg’s Financial Fiasco: How America’s Infatuation With Homeownership and Easy Money Created the Economic Crisis in Foreign Affairs:

The economic crisis of 2008-9 will no doubt spawn dozens of books. Here are two good early ones….

Norberg, a knowledgeable Swede, provides a much more detailed account of the broader events of 2007-9, from the useful perspective of a non-American. He finds plenty of blame with all the major players in the U.S. financial system: politicians, who thoughtlessly pushed homeownership on thousands who could not afford it; mortgage loan originators, who relaxed credit standards; securitizers, who packaged poor-quality mortgage loans as though these were conventional loans; the Securities and Exchange Commission, which endowed the leading rating agencies with oligopoly powers; the rating agencies, which knowingly overrated securitized mortgages and their derivatives; and investors, who let the ratings substitute for due diligence. Senior management in large parts of the financial community lacked an attribute essential to any well-functioning financial market: integrity. But solutions, Norberg warns, do not lie in greater regulation or public ownership. Politicians and bureaucrats are not immune from the “short-termism” that plagues private firms.

The other book he praises, by the way, is Paul Krugman’s The Return of Depression Economics. And oddly, his list of Norberg’s villains doesn’t include one implied in the title: the Federal Reserve Bank, which issued the “easy money” that allowed the boom to happen. Purchase Financial Fiasco here or on Kindle.

Fed Opposed by Left and Right

On its front page today, the Washington Times reports that expanded powers for the Federal Reserve are being opposed by “odd allies.”  The Fed’s imperial over-reach for additional regulatory powers is being opposed by Democrats and Republicans, and liberals and conservatives alike.  As well it should be.  As Senator Shelby observed, “Anointing the Fed as the systemic-risk regulator will make what has proven to be a bad bank regulator even worse.”

The regulation of financial services failed conspicuously to prevent the worst financial crisis since the Great Depression.  The Fed failed most conspicuously as it was charged with oversight of all the major banks, including notably Citigroup and Bank of America. Bank regulation now functions to insulate banks from the consequences of their own bad acts.  The regulatory system enables banks to engage in excessive risk taking.

The Obama Administration and Chairman Barney Frank of the House Financial Services Committee propose that an expanded role for the Fed and generally more of the same will improve matters. Instead, the proposed legislation will worsen the situation by codifying the status of the major financial institutions as “too-big-to-fail.”  It would thereby provide them with special legal status.  We have all seen this movie and how it ends.  Fannie Mae and Freddie Mac had such a status and collapsed.  Do we need 20 more such disasters?

Three cheers for all those opposing this destructive piece of legislation. End “too-big-to-fail” instead.

Is the Economy Booming Again?

The lead headline in Friday’s Wall Street Journal proclaims

Economy Snaps Long Slump

But buried on page C10 is a more skeptical view:

If the Obama administration were managing a company, it might have hoped the latest gross-domestic-product numbers would be greeted with cries of “great quarter, guys!”

At least the stock-market obliged, rising on the back of better-than-expected GDP data Thursday morning. But then bulls have become used to looking to Washington for inspiration. Zero rates and stimulus programs boost economic data as well as nudge money toward riskier assets.

Fully 2.2 percentage points of the third quarter’s 3.5% growth figure related to vehicle purchases and residential construction, both juiced by government support. Federal spending added 0.6%.

If these GDP data were company earnings, they would be what analysts euphemistically call “low quality.” Investors buying into the market off the back of them are ignoring weekly unemployment-claims data that came in above 500,000 again on the same day.

The danger is that all these short-term fixes leave the economy dangerously addicted to taxpayer-funded steroids. The circularity in the housing market, whereby Washington provides tax breaks to first-time buyers, guarantees most of the mortgages written, and then buys most of those, beggars belief, and suggests a worrying case of amnesia following the bursting of the housing bubble. (emphasis added)

Johan Norberg warned about the dangers of repeating the very mistakes that created the bubble and bust in the first place in Financial Fiasco: How America’s Infatuation with Homeownership and Easy Money Created the Economic Crisis (available in hardcover, e-book, or Kindle).

The Fed and Policy Uncertainty

How and when should the Fed unwind the enormous monetary expansion it undertook in response to the financial crisis and recession? The WSJ reports [$]:

As the Federal Reserve’s next meeting approaches in early November, an internal debate is brewing about how and when to signal the possibility of interest-rate increases.

The Fed has said since March that it will keep rates very low for an “extended period.” Long before it raises rates, however, it will need to change that public signal to financial markets.

Because the recovery is so young and is expected to be so weak, many central bank officials are comfortable, for now, keeping rates very low. But they are beginning to strategize about how to walk away from the “extended period” language.

My suggestion is that the Fed announce a path of gradual increases in the federal funds rate, say beginning next year and lasting for two years, until the rate is at some “normal level.”

This approach is different than what the Fed is likely to undertake; it will probably want to maximize “discretion,” the ability to adjust on the fly as conditions unfold.

My approach maximizes predictability and reassurance: it commits the Fed to shrinking the money supply and heading off future inflation. This reassures markets and takes substantial uncertainty out of the picture.

The problem with my approach is the pre-commitment: everyone knows the Fed could abandon a pre-announced path.

But such an announcement might still give markets useful guidance, and the Fed would know that any deviation would itself upset markets, and this might encourage adherence to the pre-commitment.

C/P Libertarianism, from A to Z

Crist and Cato

Florida’s airwaves are alive with the sound of Governor Charlie Crist’s radio advertisement trumpeting his grade of “A” on Cato’s “Fiscal Policy Report Card on America’s Governors.”

I am pleased that Gov. Crist values Cato’s ratings because we work hard to make them accurate and nonpartisan. But the radio ad is making many fiscally conservative Floridians scratch their heads because of the governor’s recent policy actions.

The governor earned his Cato grade in last year’s report mainly because of his large property tax cuts and moderate spending approach. The grade was based purely on quantitative data on revenues, general fund spending, and tax rate changes.

However, since I wrote the report in mid-2008, the governor seems to have fallen off the fiscal responsibility horse.

In particular, Crist approved a huge $2.2 billion tax increase for the fiscal 2010 budget, even though he had promised that $12 billion in federal “stimulus” money showered on Florida over three years would obviate the need for tax increases.

About $1 billion of the tax increases are on cigarette consumers, which will particularly harm moderate-income families. The rest of the increases are in the form of higher costs for often mandatory services, such as automobile registration, which is really just a sneaky form of tax increases.

These tax increases will be particularly painful to Floridians in the short-term because of the recession. But Crist has also jeopardized the state’s long-term finances with his expanded subsidies for hurricane insurance. Hurricanes are a major challenge in Florida, but giving big subsidies to coastal property owners, driving private insurers out of the state, and guaranteeing a massive state bailout when the next hurricane hits strikes me as the height of fiscally irresponsibility.

More on the Crist campaign here.

Executive Comp Restrictions Could End Up Costing the Taxpayer

The Obama administration’s announcement this week on cash compensation for those seven institutions receiving “extraordinary assistance” has generated the all-too-predictable responses. Either you think executives at the entities are bad and greedy and should be punished, or you believe this is just the first step in an all-out class war.  Sadly the real victim in all these efforts has been, and continues to be, the taxpayer.

Now that the taxpayer is the most significant shareholder in these companies, the top priority for Washington, as representative of the taxpayer, should be to see these companies return to profitability.  Quite simply, if these companies are not profitable, that loss will fall on the taxpayer, as shareholder.

And of course, without the ability to retain talent, it is all the more likely that these companies will not maintain profitability.  I suspect the competitors of these seven are already eyeing their best talent.  And let’s not kid ourselves, leaving these companies stocked with mediocre employees will not help taxpayers get their money back. 

In trying to punish the bailed-out  companies, we are also punishing ourselves.  This is one of the very reasons we should never have bailed them out in the first place:  once we are the owners, there fate and ours are linked.

Nothing Good about The Higher Ed Pricing Game

On Tuesday I noted that the College Board had released its annual reports on college prices and student aid. At the time I wrote the post I hadn’t yet been able to download the reports, but was planning to provide a rundown of their major findings once I’d read them. I’ve now done the latter, but it turns out that Ben Miller over at the Quick and the ED has already posted a pretty good summary of the most important findings. Go there if you want the highlights. Don’t go there, though, if you want to know what the highlights mean, at least for anyone other than students. For that, you’ll have to read on here….

The big news is that net college prices – what students pay after aid– have actually decreased over the last 15 years. While sticker prices were rising much faster than incomes and inflation, what students were actually paying dropped. The implication of this is so obvious that Mr. Magoo couldn’t mistake it: Student aid, much of which comes through taxpayers, enables schools to charge ever-higher prices with near impunity.

Back to the Quick and the ED. To some degree, Miller sees declining net price as a triumph for federal aid, making college more affordable even as prices explode:

This story should be encouraging for legislators that fought hard to win Pell Grant increases over the last few years. The steepest decreases in net price occur beginning in the 2007-2008 academic year, the same time Congress began passing legislation that boosted the maximum Pell Grant award several times. This at least suggests that the money spent on the program did play some role in lessening the financial burden for students and was not completely eaten up by sticker price increases.

On the flip side, Miller at least acknowledges that:

The net price figure also lessens the pressure on schools to actually take proactive steps to lower their costs. If the price you list isn’t actually what you charge, then why should anyone care what the listed price is and how high it gets? Net price thus serves as a kind of smokescreen that gets colleges at least partially off fo[r] charging an arm and a leg.

So what’s wrong with this analysis? 

Most important is that Miller softpedals the aid effect, suggesting that the main negative consequence of  ever-increasing assistance is that it bleeds off a bit of the pressure for schools to lower costs. But it likely has a much more destructive effect than that, not just curbing efficiency pressures, but enabling schools to constantly charge and spend more.  It’s a likelihood that student-aid defenders try to dispel by citing studies that cover very short periods of time, or that simply pronounce that we don’t know that it happens. That it probably happens, however, has been borne out empirically, and it’s readily ackowledged by prominent higher educators including former Harvard president Derek Bok, former Stanford vice president William F. Massy, and former University of Iowa president Howard Bowen. Indeed, the latter’s “law” couldn’t be more blunt: “Universities will raise all the money they can and spend all the money they raise.”

Miller’s other major failing is that he completely ignores that all this aid has to come from somwhere, and that “somewhere” is largely taxpayers. (OK, first it’s China.) Just to give you a sense of the impact on taxpayers, College Board data show that between the 1998-99 and 2008-09 academic years, total federal aid – including grant money recipients don’t have to pay back, and loans they (sometimes) do – rose from $61.1 billion to $116.8 billion. Add state aid to that, and the total goes from $66.6 billion to $126.2 billion.

And what are some of the major downsides of these forced third-party payments? Miller mentions a few pricing difficulties for students, but makes no mention of the potentially huge negative consequences for the nation: Encouraging lots of people to attend college who simply aren’t prepared for it; cranking out many more degrees than the job market demands; and potentially slowing economic growth by taking funds from productive uses and giving it to efficiency-averse colleges and students. 

The big finding in the latest College Board data, which the Quick and the ED nails, is that net college prices have been going down. The important story, however, is that this is bad news for the country. Unfortunately, the Quick and the Ed misses that almost completely.