Topic: Finance, Banking & Monetary Policy

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.

Libor Lies

“Libor Fog” is the apt warning above the headline of today’s front-page Wall Street Journal piece by Carrick Mollenkamp, “Bankers Cast Doubt on Key Rate Amid Crisis.” The article is about the interest rate on loans between banks—the London Interbank Offered Rate (Libor). “A small increase in Libor can make a big difference for borrowers,” says the author. For example, “A risky ‘subprime’ mortgage loan might carry an interest rate of Libor plus more than six percentage points.”

An accompanying graph shows the spread between the 3-month Libor and the 3-month Treasury bill rate. The article explains that “the gap between the two stood at 1.58 percentage points Tuesday, and has averaged 1.39 percentage points since the crisis began in August.”

Anyone reading this article surely thought Libor had increased “since the crisis began in August.” Why else would the graph be titled “Costly Credit”? Why else would the article have emphasized the way an increase in Libor affects subprime adjustable rate mortgages?

“On Tuesday [April 15],” the article says, ‘the Libor rate for three-month dollar loans stood at 2.716%.” In July 2007– before “the crisis began in August”–that Libor rate was 5.360%.

The reason the spread between Libor and Treasury bills widened is not that Libor rates have increased but that 3-month T-bill rates fell from 4.95% last July to about 1.2% lately, thanks to Fed easing and a flight to quality. That drop of 3.75 percentage points in T-bill rates since last July was even greater than the 2.65 percentage point drop in Libor, so the spread between the two widened. So what??? You and I can’t borrow at the T-bill rate either.

Like other factually misleading news reports, cutting the Libor rate in half (“since the crisis began in August”) is not what most people think of as a “credit crisis.”

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.