Topic: Finance, Banking & Monetary Policy

A Health Fed?

Lots of people, on both the Left and the Right, want government to plan economic activity.  Honest central planners recognize that highly concentrated and well-organized groups of producers and consumers typically hijack the plan’s new taxes, subsidies, and regulations.  The central planners are typically horrified to see what their carefully laid plans look like after being put through the political grinder.

Clever central planners look for ways to protect their plans from the influence of their fellow citizens.  For example, some planners seek to restrict their fellow citizens’ right to petition the government for a redress of grievances.  (I have often remarked that if you can’t implement your plans without taking away someone else’s First Amendment rights, maybe you should rethink your plans.)

Other central planners seek to create special government bodies to execute their plans.  These bodies would have the power to tax, spend, and regulate, but their decisions could only be overturned by the people’s representatives with great difficulty.  Indeed, the very purpose of these bodies is to allow the planners to govern their fellow citizens without having to worry so much about the consent of the governed. 

Certain health care reformers have set about this path.  Across the political spectrum, observers acknowledge that government wields enormous power over America’s health care sector, and that those powers are often co-opted to serve private ends.  For example, former Senate Majority Leader Tom Daschle (D-SD) recently remarked:

Congress is just not capable of being the manager of a health care system and yet it’s largely Congress today that has that responsibility. It hasn’t worked for the last 50 years. It’ll work even less in the next 50.

As a result, Daschle and others propose that Congress create a “federal health board” to manage the health care sector.  The Federal Health Board would do things like require you to purchase health insurance, dictate what kind of health insurance you will purchase, set the prices for health insurance and medical goods and services, etc..  In other words, the Federal Health Board would have the power to bankrupt corporations, to force doctors to change the way they do business, to deny medical care to patients, and to shift massive amounts of resources from one part of the country to another.  The problem is, some corporations, doctors, patients, and regional interests would try to block parts of The Plan, either on their own or through their representatives in Congress.

Since it would be so hard for the Federal Health Board to do its job with all that meddling by the governed, Daschle et alia want to insulate the Board from the political process.  Specifically, they want Congress to model a new Federal Health Board on the existing Federal Reserve Board.  That would enable the “health Fed” to focus on the public good, much like the Federal Reserve Board manages the money supply and guides interest rates without any of the unseemly pandering to special interests that goes on in Congress and other government bodies.  Because that’s how the Fed operates, right?

Maybe not.  Economist Allan H. Meltzer of Carnegie-Mellon University has read the transcripts of every meeting of the Fed’s Open Market Committee going back to 1913, and has written a two-volume history of the Federal Reserve.  Interviewed recently for one of Russ Roberts’ excellent EconTalk podcasts, Meltzer dismissed the idea that the Federal Reserve is immune from political pressures:

We talk about an independent Federal Reserve, but in reading and writing the history of the Federal Reserve, there are very few occasions since the 1930s when the Fed actually practiced independence.  There was the [Paul] Volcker era; he was certainly an independent central bank governor.  But [current Fed chairman Ben] Bernanke is anything but an independent central bank governor.  He is being leaned on by the Congress, and he accedes to them.  So even though he may worry about inflation … he’s … trying to respond to the short-term pressures instead of thinking ahead and thinking longer-term …

That brings him to the interest rate, because that’s the thing that people in the market see.  The Wall Street people …  put him under great pressure because they own a lot of bonds and mortgages.  And they believe that if he lowers the federal funds rate, it will lower the price of their mortgages and bonds, and they will have smaller losses.  And so they are on his back all the time to do more, to cut the interest rate that he controls, hoping that the rates that they see and own will go down, and their … losses will become smaller …

In reading the minutes of the Fed and watching what they do, the Fed has always been very much afraid of Congress.  And it took someone with the stamina and arrogance, in a way, of Volcker to be able to get around that … By the summer of 1982, [Congress was] facing an election and they were on his back to ease up … He wouldn’t admit that he was [easing up], but he did …

The idea of having a really independent agency in Washington, that’s just not going to happen … The Federal Reserve derives its power from Congress … The Fed’s power is delegated, and they are very much aware that Congress could always change that … [The Fed] manages to hang on to some measure or vestige of independence, but it is very much concerned – always – about what the Congress is doing, and doesn’t want to deviate very far from that.

What can’t come through in a transcription is that Meltzer chuckled at “the idea of having a really independent agency in Washington.”

So if the central planners seek to insulate their health care reforms from the political process, modeling a new health planning board on the Fed won’t achieve that goal.  That’s probably a good thing.  Power with accountability is dangerous enough.  Power without accountability is truly frightening. 

An important advantage of free-market health care reforms is that they provide accountability without allowing anyone to consolidate much power at all.  That seems a much happier state of affairs.

Re: Wall Street Journal Editorials — The Fed Caused the Rise in Food and Oil Prices?

In numerous unsigned editorials, The Wall Street Journal has argued that cutting the federal funds rate to 2% from 5 1/4% last September has been the main reason prices of crude oil and food commodities have soared in recent months. Such commodities are priced in dollars and the dollar was generally falling through February, though not in the past two months (even though the funds rate was reduced by one percentage point).

An April 28 editorial, “The Fed’s Bender,” notes that “since 2003 the dollar price of oil has climbed far more rapidly than the euro price — 273% in dollars, compared to 146% in euros.” It is not likely that the whole 2003-2008 picture reflects “the European Central Bank’s sounder monetary management,” as the editorial implies. The euro had dropped to below parity with dollar until late 2002. And the fed funds rate was repeatedly increased from 1% in 2003 to 5 ¼% in mid-2006 (well above the ECB’s equivalent 4% rate). The euro rose partly because it had first fallen, but also for reasons other than central bank interest rates (economists have no reliable model for forecasting floating exchange rates).

The editorial boldly concludes that “had the dollar merely retained the same purchasing power as the euro, today’s price of oil would be below $70 a barrel.” That is a counterfactual exercise that makes little sense.

Even if we accept the half-true premise that the dollar-euro exchange rate is sensitive to relative short-term interest rates, the dollar might have “retained the same purchasing power as the euro” by having the ECB lower interest rates to 3% and the Fed to keep ours at 3%. Or the Fed might have kept the funds rate at 5% and the ECB at 4%. Although either option might have stabilized that particular exchange rate, they would not have had the same effect on global economic growth and therefore on the world demand for oil.

If oil had been priced in dollars and the euro had not appreciated against the dollar, then the euro area would not have been as insulated as it was against the rising cost of oil. Because demand is responsive to price (particularly business demand), Europe would have bought less oil than it did. Or, to use the editorial version, if the U.S. still faced $70 oil then we would try to buy more. Either way, the price in dollars would not have remained the same.

The Economist index covers the prices of 25 commodities, excluding oil and gold, with food accounting for 56% of the index. By April 22 it was up 31% for the year and 3.7% for the month, when measured in dollars.

That was mostly because of food. Industrial commodities were up only 1.6% for the year.

If we are going to blame the rising price of oil and food commodities on the dollar, do we need a different theory to explain why industrial commodities have barely risen?

Here’s another anomaly: Measured in British pounds, the commodity index was up about the same as it was in dollars—31.6% for the year and 4% for the month. That can’t be because Britain has a weak currency—the pound buys 8.9% more dollars than it did a year ago. It can’t be because the Bank of England cut interest rates too much, since 3-month interest rates are 5.86% in Britain, compared with 1.97% in the U.S.

I happen to agree that the Fed (and ECB) have paid too little attention to the impact of exchange rates on prices of internationally traded commodities. And I suspect the Fed has already gone too far with rate cuts and will have to put rates back up shortly after the election. But to single-out a few sensitive commodity prices that have risen the most (in dollars or pounds) and blame just those prices on the Fed is going too far.

Re: Martin Feldstein — The Fed Should Stop Helping Commodity Speculators?

In The Wall Street Journal on April 15, Martin Feldstein of Harvard took a position between Makin and Chapman, saying the Fed should have left the federal funds rate at 2 1/4%, because a lower rate would cause “rising food and energy prices.” Feldstein told The Guardian the dollar had to fall further on April 11, so the link he envisions between Fed policy and commodity markets is not through exchange rates (I’ll discuss that in a later post), but just upside speculation alone:

Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates.

But investors go short as well as long–betting the price will fall– and they can use credit for that too.

The only reason to make a leveraged bet that the price of oil, gold or corn will go higher is if you expect the prices to rise by enough (during the holding period) to exceed the interest expense.

Ignoring trading costs, if you can borrow at 5% to invest in something whose price is expected to rise by 8% that may look like easy money. Yet oil futures are cheaper than near-term spot prices, and gold has recently fallen by about 13%, so momentum trading is dangerous. It is properly called “greater fool investing” – just like paying too much for a Las Vegas condo on the assumption that some greater fool will later pay even more.

It seems unlikely that today’s quarter-point cut in the fed funds rate will result in lower margin rates for commodity traders. But even if it did that is not nearly enough to make a significant difference for more than a day or two.

U.S. politicians seem equally angry with upside “speculators” and downside “shorts,” but it is the contest between the two that constantly gropes for the right price.

I am shorting oil through an exchange-traded fund (DUG), and shorting precious metals through a mutual fund (SPPIX). I’m also slightly long the dollar (UUP). Don’t try this at home without a net. But if I win those bets, the world economy wins too.

Re: John L. Chapman — The Fed Should Tighten to Slow the Growth of MZM?

In The Wall Street Journal on April 29, another AEI economist, John L. Chapman, took the exact opposite position from John Makin. Chapman suggested the Fed “should soon begin a series of rate increases.” The title was “The Fed Must Strengthen the Dollar,” but that is not what he wrote. Chapman just advocated “a stable dollar.”

The dollar was stable in March and April. The Fed’s index of the dollar’s value against a broad basket of currencies (Jan. 1997=100) was 95.84 on March 6 and 95.81 on April 29. The index against major currencies (1973=100) remained close to 70. That was just two months, of course. But those were the months when we were deluged by editorials blaming rising prices of food and oil on “the falling dollar.” In any case, if the goal is being achieved with current Fed policy, then changing that policy would mean deviating from that goal.

Chapman, like some other economists, sees “inflation warnings” in rapid growth of a measure of money supply (or demand) known as MZM (money with zero maturity), which is largely driven by institutional money market funds. These short-term investments tend to expand when corporations and financial fiduciaries are nervous about investing longer-term, and therefore park more cash in money market funds for security.

The trouble with using MZM as an omen of inflation is that it has never worked.

MZM grew rapidly in 2001, during a recession, but MZM was nearly flat in 1973 when inflation began to explode. MZM fell from $854.3 billion in September 1978 to $827.3 billion in April 1980, yet this was a period of rapidly escalating inflation. Core inflation, excluding food and energy, reached 8.5% in the year ending December 1978, then 11.3% and 12.2% in the following years.

There may be an argument for raising the fed funds rate whenever oil and food prices rise, but MZM is not it.

Re: Ronald McKinnon — The Fed Should Tighten to Push the Euro Down?

In The Wall Street Journal of April 25, Ronald McKinnon of Stanford proposed “raising the fed funds rate as much as necessary to strengthen the dollar.” McKinnon’s argument had little to do with inflation, so he could just as well have asked the European Central Bank to lower interest rates as much as necessary. Yet he just asked the U.S. to “cooperate with foreign governments to halt and reverse the appreciation of their currencies against the dollar.”

McKinnon’s main argument for raising the fed funds rate is because he imagines that “foreigners are disinvesting from private U.S. assets.”

Net foreign purchases of U.S. stocks in the fourth quarter were $55.6 billion. Net foreign purchases of U.S. corporate bonds were $39.1 billion. Foreign direct investment in the United States increased by $39.9 billion in the fourth quarter, following an increase of $101.3 billion in the third.

There will surely be a good argument for raising the fed funds rate, sooner or later, but an exodus of foreign investment is not it.

Re: John Makin — The Fed Should Ease to Inflate House Prices?

The Wall Street Journal has been extremely ecumenical about airing a variety of critics of the Federal Reserve on its editorial page. In a series of posts, I will suggest reasons for remaining skeptical about the logic and evidence behind all of this policy advice.

On April 14, John Makin of the American Enterprise Institute proposed, “The Inflation Solution to the Housing Mess.” He thinks, “The Fed should announce its intention to add to its holding of Treasury securities in order to provide additional liquidity.” Makin knows “there is a substantial risk that inflation may rise for a time – this would be the policy goal.”

To establish higher inflation as a “policy goal” gives a small part of the economy (the existing inventory of new and used homes) priority over the rest (he does not and could not claim inflation would be confined to housing). He thinks easy money could halt declines in the Case-Shiller index of homes prices, although I have shown that index is not representative of nationwide housing prices

Makin argues that

the Fed’s lending programs have not provided adequate liquidity to financial markets: Reserves supplied to the banking system have grown at a tiny 0.6% annual rate since December. That’s because the reserves the Fed is injecting by lending are effectively pulled out or “sterilized” by its sales of Treasury securities. The Fed has been selling these securities to keep the fed funds rate at the level targeted by its Federal Open Market Committee directives.

But it doesn’t matter whether the Fed increases the monetary base (reserves and currency) by buying Treasury bills, gold bars, or Bear Stearns’ securities. In each case the Fed pays for new assets by writing a check on the Fed which ends up being added to bank reserves at the Federal Reserve banks.

The biweekly bank reserve data bounces around too much to speak of an annual rate of change between two dates. Reserves were $91.8 billion in the two weeks ended October 24 and $97.1 billion by March 26, but converting that into an annual rate of change would be just as misleading as Makin’s selective comparison.

Bank loans have been growing at a 10% annual rate this year, with Commercial and Industrial loans growing at a 20% pace. This does not look at though the banks are starved for reserves or that the Fed is “pushing on a string.”

Makin’s inference that monetary policy is too tight is dubious but also redundant. He clearly wants inflation to be higher, as a policy goal.

The Housing Crisis: Maybe We Should Do Nothing?

Two weeks ago, the Senate passed legislation ostensibly intended to address home foreclosures. That legislation is now being criticized as little more than a handout to corporate interests. The criticism is legit; the bill is largely a package of tax breaks for developers (and other struggling industries, including those that have nothing to do with housing), along with tax credits for the purchasers of foreclosed homes (a provision that has its own criticisms) and grant money to local governments that want to play Flip This House.

Across Capitol Hill, the House is considering different foreclosure legislation that would give tax credits to first-time homebuyers and developers of lower-cost housing (proposals that are subject to some of the same criticisms now being lobbed at the Senate bill). House and Senate committees are also considering additional legislation that would permit the Federal Housing Authority to underwrite as much as $300 billion in mortgages for borrowers who are at risk of falling behind on their payments.

Lawmakers’ interest in combating the mortgage problem is understandable: default and foreclosure are painful for homeowners, clusters of vacant houses are hard on communities, and the struggling homebuilding industry is a significant contributor to the nation’s overall economic malaise. (Another factor that makes it understandable: this is an election year.)

However, before Congress puts taxpayers (most of whom are also paying mortgages or renting their homes) on the hook for billions of dollars in grants, tens of billions in tax breaks, and guarantees for hundreds of billions of dollars in mortgages, three points should be acknowledged:

  1. The bailout proposals are as much a benefit to lenders as borrowers.
  2. The homebuyers who are to be rescued are not the victims of “raw deals” (unless they were deceived or defrauded).
  3. The bailout could make the nation’s overall economic condition worse.

The housing market turmoil is the product of two related factors:

  • a decline in house prices in several geographic areas that were super-heated in recent years, and
  • the discovery that many mortgage borrowers are higher-risk than lenders had previously realized.

As long as house prices were rising, the risky borrowers were not a problem. Borrowers who fell behind in their payments could sell their houses (and usually reap capital gains). But when the market reversed, this “escape hatch” closed and defaults and foreclosures ensued.

The home loans at the heart of the mortgage meltdown are “subprime” loans — loans made to borrowers with less-than-stellar credit and/or little money down. Though subprimes constitute only 12.7 percent of all outstanding mortgages, they comprise 55.2 percent of mortgages that are in foreclosure. (Mortgage figures are calculated using data from the most recent National Delinquency Survey.)

The fact that subprime loan defaults are (literally) breaking the investment banks indicates that lenders were charging subprime borrowers too little — that subprime borrowers’ mortgage payments weren’t sufficient to cover their risk of default. That’s why investment banks are suffering severe write-downs (and in the case of Bear Stearns, near collapse) and brokerage firms have needed capital infusions. Those firms would benefit greatly from many of the proposed government interventions, even if they have to take a “haircut” on their loans. Hence, claims that bailout legislation is intended to “help Main Street, not Wall Street” should be taken with grains of salt.

Further, consider that 73.3 percent of the subprime loans in foreclosure are adjustable rate mortgages (ARMs). ARM borrowers not only paid lower rates than what their default risk merited, but they also paid even-lower introductory rates for the first few years of their mortgages. In essence, the borrowers entered into “lease-to-buy” contracts, with the “buy” provision kicking in when the ARMs reset to higher rates. The increased foreclosures can be understood as borrowers deciding not to exercise the “buy” portion of the contract, either because the terms are relatively unaffordable or because the house is no longer worth the contracted amount.

Commentators err when they describe these borrowers as being irresponsible or foolish for signing such contracts. The borrowers simply made a risky but reasonable decision to try to buy a house, on very generous terms given their default risk, in a market that was experiencing tremendous appreciation. They are now making a reasonable decision to bail on their contracts and go back to renting in the wake of the housing market downturn. Of course, the borrowers feel pain when they lose their homes. But, unless they were deceived or defrauded, they were not the victims of raw deals.

Moreover, for the overwhelming majority of subprime loans, the borrowers’ original decision to buy has worked out nicely — more than 80 percent of subprime loans (and just under 80 percent of subprime ARMs) are currently in good standing. Moreover, many of the people who have used subprime loans, ARMs, and other oft-denigrated “exotic vehicles” over the past decade have realized significant capital gains, even with the recent decline in house prices. If some so-called “consumer advocates” get their wish and regulation is implemented to curtail or prohibit the use of subprime loans and ARMs, higher-risk would-be homebuyers as a group will be harmed.

Another worry is that the bailout and other interventions could make overall economic matters worse. The United States’ current economic malaise is partly the product of the housing market collapse and the associated mortgage woes, but it is also partly the product of higher energy prices. Put simply, current conditions indicate that market actors need to shift their investment and risk-taking away from housing and toward energy development and conservation.

However, government and Federal Reserve efforts to combat the housing crunch and the financial crisis could dampen the incentives to make that necessary investment switch. Ready money makes it easier to delay painful but necessary changes.

Economic corrections are always painful, but as GMU economist Alex Tabarrok and WaPo columnist Robert Samuelson each recently wrote, the pain is increased if the correction process is drawn out. Tabarrok’s NYT column compares the recent U.S. housing experience with Japan’s dramatic boom-and-bust cycle of 1985–2000. We should be mindful of Japan’s broader experience over the 1990s: the government struggled mightily to blunt the pain of a correction, resulting in an agonizing decade of economic stagnation.

All of this raises the question: Should government intervene at all in the foreclosure mess? In asking this, I’m not arguing that struggling borrowers should drop dead. But there is much more downside risk and much less justification for intervention than what proponents have acknowledged.