Topic: Finance, Banking & Monetary Policy

Rebate Folly

I was exploring some old CBO reports for information on dynamic budget scoring and I came across this nugget:

If a tax cut—such as a rebate or a higher standard deduction—does not reduce the tax on income from an extra hour of work, the additional income will create an incentive for people to cut back their working hours and spend more time at home. Not everyone will respond, but some people (especially second workers in a family with one full-time earner) may decide to leave the labor force to care for children or aging parents or to pursue other interests.

(Supplement to CBO’s May 9, 2002, Testimony on Federal Budget Estimating May 2002 CONGRESSIONAL BUDGET OFFICE, page 9)

We are about to receive a rebate in May this year as part of the economic stimulus that Congress passed in February. I suppose the folks at the CBO would have pointed out that although a rebate may stimulate consumer spending, it is also likely to reduce labor supply. The net impact, therefore, would not necessarily involve any increase in national output but it would certainly induce stronger inflationary pressures—adding fuel to the inflationary fire the Fed’s apparently stoking by cutting interest rates so rapidly. So it’s perhaps not surprising that the dollar’s value took a nosedive during February this year.

Higher rebate-induced debt and higher inflation implies higher future interest rates and, therefore, increased cost of financing consumer and investment spending. Rebate recipients will benefit today, but everyone will lose in the long-term as the economy becomes more sluggish.

Bottom line: Politicians gain by appearing to be doing something – and most of us lose!

Monetary Mercantilism

Chile’s Central Bank has finally decided to intervene in the local currency market in order to avoid a further appreciation of the peso against the U.S. dollar. In doing this, Chile joins a monetary policy trend that includes most Latin American countries, particularly Argentina, Bolivia, Peru, Colombia, Costa Rica and Guatemala.

Until recently, Chilean monetary policy was regarded as an example for all Latin America. Chile was mentioned frequently — especially by defenders of “monetary sovereignty” — as a model of how a Latin American country can have both a national currency and monetary stability.

However, alarm bells started ringing last year when inflation tripled to almost 8 percent, mainly because of an excessive increase in public spending by the government of Michelle Bachelet. Now, by deciding to abandon the historic policy of free floatation of the peso, Chile’s Central Bank further compromises this year inflation’s target.

Aiming for a cheaper peso will prove very expensive for Chileans.

Paul Krugman’s Fallacious Forecast of a $6-7 Trillion Drop in Housing Wealth

The Case-Shiller index of house prices covers just 20 major metropolitan areas. It shows house prices down by 10.7% between January 2007 and 2008, but that largely reflects the fact that Los Angeles, San Diego and San Francisco account for 27.4% of the index.

In Fortune magazine’s March 17 interview, economist Paul Krugman says “We’re probably heading for $6 trillion or $7 trillion in capital losses in housing.”

Such estimates begin by assuming the S&P Case-Shiller index of house prices (which is now down 12.5% from its peak month) has a lot further to fall, and that it accurately represents the value of all real estate held by U.S. households throughout the 50 states.

The Federal Reserve’s Survey of Consumer Finances (updated with flow-of-funds data by David Malpass of Bear Stearns), shows U.S. real estate worth $22.5 trillion in the fourth quarter—up 2.5% from a year earlier and accounting for 31.2% of household wealth.

If you think the Case-Shiller index will eventually fall by 30% (Krugman said 25%), then 30% of $22.5 trillion would yield an estimate of $6-7 trillion capital losses “in housing.” But the $22.5 trillion is not just single-family homes—it includes commercial property, apartments and farm land. More important, even single-family housing wealth is not located in only 20 major metropolitan areas.

The Office of Federal Housing Oversight (OFHEO) index covers all 50 states, including nonmetropolitan areas, but not the most expensive homes (which is not where Case-Shiller finds the biggest declines). The OFHEO index shows house prices down 3% in January, compared with a year before. But even that average is by no means typical of all housing (much less real estate) in the entire nation.

Between the fourth quarters of 2006 and 2007, house prices rose in all but two of the many states excluded by Case-Shiller, and the increase averaged 3.8 percent.

Economists and journalists who use gloomy predictions about the Case-Shiller index to predict a comparable loss of real estate wealth are making several serious mistakes.

Tyler Cowen Thinks Frozen Markets Justify Tougher Regulations?

In a New York Times piece of March 23, “It’s Hard to Thaw Frozen Markets,” Tyler Cowen concludes that “regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions.” That conclusion follows from a surprisingly innocent confidence in regulation in general and capital requirements in particular. But it also follows from a faulty analysis of the situation.

Cowen writes, “What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values… .The results have been a form of financial gridlock.”

To explain this alleged “drying up” process he says, “Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.” Cowen thinks “market prices have been drained of their informational value” in “many asset markets.”

With the possible exception of mortgage-backed securities, that seems fanciful if not absurd. The spread between junk bonds and Treasury widened mainly because Treasury yields fell, but there is massive trading in such bonds. Sales of nonfinancial commercial paper have grown briskly this year, and so have sales of financial paper aside from the “asset-backed” variety. There may be little trading of mortgage-backed securities, but that just suggest many owners (unlike, say, e-Trade) are in no hurry to sell at prices low enough to attract borrowers.

This poses a temporary problem for mark-to-market accounting (and Basle’s bureaucratic capital standards), but this seems a failure of accounting rather than markets. Cowen asks “why seek ‘fire sale’ prices when you might lose your job for doing so?” I would ask, “Why seek ‘fire sale’ prices if (unlike Bear Stearns) you are in a position to wait for a better deal once the market calms down?” Cowen says, “Only so many financial institutions have the size and expertise to buy up low-quality assets in large quantities.” But large holdings can often be sold in smaller batches. And we don’t know who might have bought Bear Stearns, warts and all, were it not for favoritism the Fed and Treasury showed to a single bidder (who was shamed into quintupling the offer).

Liquidity refers to the ease with which various assets can be converted to cash without dropping the value of the asset. Hedge fund managers bought gold on margin at $1000 may find it is less liquid than they expected. But what seems terrible to sellers of marked-down assets (e.g., of Las Vegas condos) can seem wonderful to buyers.

Most people think “liquidity drying up” means banks have cut back on lending, which is demonstrably false – bank loans are growing at a 10-11% annual rate since August, and much faster for C&I loans. Consumers and small businesses were never dependent on mortgage-backed IOUs.

There is no “financial gridlock” for most assets, even real estate (31% of household wealth). Auctions for foreclosed properties are drawing plenty of bids.

Mr. Cowen thinks “investors are instead flocking to the safest of assets, like Treasury bills.” Smart investors shun long-term Treasuries and are flocking to stocks, particularly U.S. stocks. The S&P 500 is down less than 10% this year – much better (in dollars) than most other markets, including Europe and China.

Tyler says, “Every step of the way, the pricing of [Bear Stearns] stock has surprised the market.” Really? It didn’t surprise the shorts, who owned a fourth of the shares. I own the SKF exchange fund (ultra-short financials) which, ironically, fell sharply a couple of days after Bear was sold out by omniscient and kindly government regulators.

Nobody ever said housing was a liquid asset, but even housing is far more liquid than the doomsday crowd imagines. The OFHEO index shows that home prices increased in all but 11 states between the fourth quarters of 2006 and 2007. Home prices fell 4% to 7% in California, Nevada, Florida and Michigan, but home prices rose 4% to 9% in 16 other states—most of which are not even counted in the widely-cited Case-Shiller index (which gives California a 27% weight).

The only problem with financial markets is that information is never free, and it sometimes takes time to discover market-clearing prices. The solution is not more regulations, but more patience.

Capital requirements, on the other hand, can cause very serious problems. The 1988 Basle Accord on capital requirements was a heavy-handed reaction to the 1982 LDC debt crisis. It was also one reason Japan’s monetary base shrunk by 2.8% a year in 1991-92 – the start of a period some U.S. journalists are now foolishly comparing to the restoration of sanity in coastal housing prices.

As I explained ten years ago, Basle “required that by the end of 1992 banks had to maintain capital equal to a minimum of 8 percent of risk-adjusted assets, where risk just happened to be defined in a way that favored government bonds over business loans… . Did relatively higher capital ratios in the United States and Great Britain mean they were less exposed than Japan to LDC default? On the contrary, even in the late eighties outstanding LDC loans still amounted to 93-199 percent of the capital of the largest U.S. banks, and as much as 82 percent for British banks, but only 55 percent for Japan. American banks seemed to have more capital. But unlike Japan, all of the capital of U.S. banks, and sometimes much more, was exposed to LDC default.”

Even if markets for a few risky, exotic U.S. securities appears “frozen” for a short while, that is far less problematic than imposing stern, politicized regulation over a wide array of assets and institutions.

The Wall Street Journal, the Dollar and the Fed

Today’s Wall Street Journal editorial, “The Buck Stops Where?” is the latest in a long series of editorials and articles suggesting the Federal Reserve has been “reckless” to cut interest rates on bank reserves. This story relies heavily on some questionable arguments about the dollar’s exchange rate.

Here are some quotes from the editorial followed by my comments:

  1. “The flight from the dollar has made U.S.-based investments less attractive at a time when the U.S. financial system urgently needs to raise capital.”

    That is almost backwards. It now costs fewer Euros or yen to buy U.S. shares or build U.S. plants than it did a few months ago, which makes U.S. investments more attractive to foreigners, not less attractive. It is true, however, that if the dollar were expected to fall sharply in the future, then risk of exchange rate losses might discourage foreigners from buying dollar-denominated assets and also encourage U.S. investors to buy foreign securities.

  2. “If the dollar had merely retained its value against the euro, oil would be in the neighborhood of $70 a barrel. Dollar weakness explains a large part of the oil price surge.”

    The reason a lower dollar makes oil prices rise is that it makes oil cheaper than it would otherwise be in euro, so Europeans buy more oil than they otherwise would – bidding-up the price (at least in dollars). We can’t be sure what would have happened to oil prices if the Fed had kept interest rates on bank reserves high enough to maintain the dollar’s value against the euro, because higher U.S. interest rates would have had some adverse effects on the world economy (and therefore on industrial demand for energy). If the euro had been stabilized by cutting ECB interest rates, by contrast, the effect on oil prices would have been much different. The oil price is a ratio of barrels to dollars, which means it is partly real and partly monetary.

  3. “Exports in goods are being more than offset by the rising cost of oil imports.”

    Actually, the U.S. current account deficit in fourth quarter was down 12.7% from a year before. Incidentally, purchases of U.S. government securities by foreign central banks were reduced by $148.8 billion last year, while private foreign investments in Treasuries rose by $202.1 billion.

  4. “Import prices have surged nearly 14% in the last year.”

    Import prices were up by 13.6% in the 12 months ending in February only because the price of petroleum imports was up by 60.9%. The price of all other imports was up 4.5%. While it makes some sense to blame rising import prices on dollar weakness, it does not make sense to suggest that petroleum prices are uniquely affected by the dollar, unlike most other imports.

    There is also some reverse causality–with rising oil prices contributing to a lower dollar and not just the other way around. Rising commodity prices lift the exchange rates of commodity-exporting countries like Canada and Australia, which shows up as a drop in the trade-weighted U.S. dollar.

David Malpass of Bear Stearns is an excellent economist who has supported a strong dollar in several Journal op eds. But Malpass does not argue, as the editorial page does, that a weaker exchange rate is necessarily inflationary. Indeed, one of the graphs in David’s December 6 forecast was aptly titled, “Trade-weighted dollar not well-connected to CPI inflation.” Even using 3-year trends, there’s virtually no connection.

On March 14, the Journal’s “Ahead of the Tape” column argued that the Fed is wrong to focus on core inflation, because “inflation is on the rise and energy and food have a lot to do with it.”

Should the Fed raise interest rates when world oil prices go up and lower interest rates when oil prices fall?

That is, after all, what it means to say the Fed should base policy on “headline” inflation, including energy prices (and the impact of ethanol subsidies on food prices).

While he was an academic researcher, Ben Bernanke showed that central bank reactions to oil prices have caused or aggravated virtually every postwar recession.

Recessions eventually cause oil prices to fall and central banks to ease aggressively – years after the recession is over (as in 2003-2004), as I noted in “Interest Rates and Dollar Fundamentals” (WSJ Nov. 15, 2007)

What is different this time is mainly a matter of timing – the Fed easing before recession rather than long after. What also appears different, so far, is that the Fed is acting alone, which largely explains the euro’s recent strength. Yet the ECB has always followed the Fed, after many months, and probably will again.

The Fed may be at risk of overdoing it, but making that case requires looking at some historical variables (or a model, like John Taylor’s) that have a decent track record for predicting inflation.

The trade-weighted dollar has been falling since February 2002, and the price of gold has risen nearly as long. If exchange rates or gold prices could generate reliable forecasts of inflation, then we should have seen escalating inflation for the past six years.

Should the Government Have a Monopoly on Money?

Writing for the New Republic, Alvaro Vargas Llosa asks the fundamental question of whether the Federal Reserve has been a net plus or a net minus for the American economy. Looking at the Fed’s track record, which includes disasters like the Great Depression and serious mistakes like the more recent high-tech and housing bubbles, Llosa astutely wonders whether money is too important to be left in the control of government:

Some of the country’s greatest economists, including Nobel Prize winners, have been saying for years that the Federal Reserve has probably caused more problems than it has solved since its creation in 1913. Its role in the last century’s boom and bust cycles is a matter of record; it looks as though it played a similar role in the current housing market crisis too. While the creation of the Federal Reserve was essentially a response to a series of bank runs, those crises were mild compared to the ones that were to follow. … All in all, financial instability has been far greater since the creation of the Federal Reserve. What did the Great Depression teach us? Essentially that even with the best of intentions, it is impossible for the authorities to manage the supply of money in accordance with the exact needs of the economy. A country’s economy is the sum of millions of people making decisions that no single individual is in a position to anticipate. … The current housing market and debt market crises are in good part the children of the Federal Reserve. By cutting rates 13 times between 2001 and 2003, and then keeping them very low for years, monetary policy contributed to the housing bubble. …once again, the Fed has turned out to be a factor of financial instability.

Update on Gisele and the Dollar

Maybe Gisele Bundchen is not bearish on the dollar after all. CNBC is pouring cold water on reports suggesting that the Brazilian supermodel prefers euros:

Anne Nelson, Bundchen’s manager … tells us reports that Gisele wants to be paid in euros are “false.” Nelson’s take: “Some idiot in Brazil reported something just to make news.” Nelson points out that Gisele lives in New York City, and thus needs U.S. dollars for her big-city lifestyle. Of course, anyone who disagrees with Warren Buffett’s investment wisdom does so at their own risk. But we have to think Gisele gets enough U.S. dollars that she can absorb any potential weakness against the Euro.

But this is not just a story about the strength of the dollar. The CNBC story notes that she lives in New York City, which raises the issue of whether she is a resident of the US for tax purposes. This would be a major mistake since America probably has the world’s worst tax system for people with global income. Being a selfless person concerned about the plight of the over-taxed entrepreneur, I want Gisele to know that I am willing to counsel her on how best to protect her earnings from rapacious government, even if it requires many hours and late-night meetings.

Gisele, feel free to contact me at my dmitchell [at] cato [dot] org (Cato email address). I’m here for you in your time of need.