Topic: Finance, Banking & Monetary Policy

The ‘Every Economist’ Myth

Just days after we rapped Rep. Betsy Markey (D-CO) for claiming that “every economist from the far left to the far right was saying the government needs to step in because there was absolutely no private sector investment,” Rep. Gerry Connolly (D-VA) tells the Washington Post,

You’re darn right I voted for the stimulus. Every economist, including [some] Republican economists … said, for God’s sake, don’t let it go off the cliff.

This is the myth that just won’t die. Markey and Connolly are echoing similar claims by President Obama, Vice President Biden, and even the notoriously unreliable Robert Reich. When Biden said it, Harvard economist Greg Mankiw asked if he was “disingenuous or misinformed” and pointed out:

That statement is clearly false. As I have documented on this blog in recent weeks, skeptics about a spending stimulus include quite a few well-known economists, such as (in alphabetical order) Alberto AlesinaRobert BarroGary BeckerJohn CochraneEugene FamaRobert LucasGreg MankiwKevin MurphyThomas SargentHarald Uhlig, and Luigi Zingales–and I am sure there many others as well. Regardless of whether one agrees with them on the merits of the case, it is hard to dispute that this list is pretty impressive, as judged by the standard objective criteria by which economists evaluate one another. If any university managed to hire all of them, it would immediately have a top ranked economics department.

When Robert Reich tried to claim that “economic advisers across the political spectrum support Obama’s plan,” I pointed out that that claim depended on exactly two names and that the Washington Post had demonstrated that neither of them was in fact a Republican supporter of the $787 billion stimulus bill.

In fact, of course, hundreds of economists went on record against the stimulus bill. The Cato Institute’s full-page ad with their names appeared in all the nation’s major newspapers. The ad and the economists were featured on dozens of television programs.

Which brings us back to the question that Mankiw asked of Biden and that I asked of Markey. Is Representative Connolly really unaware that there was vigorous debate among economists about the so-called stimulus bill, and that hundreds of economists expressed their opposition in every major newspaper? Connolly has lived in Washington his entire adult life. He spent 19 years on a Senate committee staff. He served for 14 years on the Fairfax County Board. He worked as vice president at two large government contractors. Is it possible that he doesn’t read the Washington Post – or the Wall Street Journal, or the New York Times, or Roll Call, the newspaper of Capitol Hill? If so, then maybe he really believes that “every economist, including Republican economists” endorsed the stimulus. Someone should ask him: misinformed or disingenuous?

How Herbert Hoover Didn’t End the Depression

Joshua Green writes in the Atlantic, after discussing the Austrian economists’ views in 1929 on what to do about the not-yet-great depression:

Herbert Hoover’s Treasury secretary, Andrew Mellon, offered similar counsel, famously urging Hoover to “liquidate” and “purge the rottenness out of the system.” But this failed to stop the catastrophe.

That’s true. And you know, here’s a general rule: Absolutely nothing that a treasury secretary says to a president will affect the real economy if the president ignores his advice and does something else.

Hoover didn’t cut federal spending, he doubled it. He established the Reconstruction Finance Corporation. He propped up wages and prices. Indeed, he launched the New Deal. And Green is right: In the face of these policies, Mellon’s memos to Hoover failed to stop the catastrophe.

The rest of the article, about Ron Paul as “The Tea Party’s Brain,” is pretty interesting.

White House Right to Oppose Moratorium

With the recent discovery of “robo-signers” and other paperwork problems in the mortgage foreclosure process, several prominent congressional Democrats have called for a national moratorium on mortgage foreclosures.  At least one large lender has already started to implement one.  A moratorium, however, would be irresponsible and harmful. And the White House is correct to oppose it.

Whatever mistakes might have been made by lenders do not change the basic fact: most foreclosures are happening because the borrower is not paying the mortgage.  I recently talked to one large lender who said of their delinquent mortgages that over a fourth have not made a payment in over two years.  How exactly is someone who has been getting two years of free rent a victim?

Of course, in the small number of cases where a real mistake has been made and a foreclosure is moving forward against a borrower who is current on their mortgage, the courts have the ability to stop that from proceeding.  In judicial foreclosure states the easiest solution to this problem is for the judge to ask the borrower, “When was the last payment you made?”  If it has been awhile, say over six months, then the foreclosure should proceed, and proceed quickly.

Its been four years since the housing market peaked.  Government policy has continued to delay the needed correction in our housing market.  A moratorium on foreclosures only puts off a turnaround in the housing market.  And if we ever expect or hope to see private capital come back into the mortgage market, then government needs to stop threatening to steal away that capital once it’s invested.  The current efforts by states to use technical mistakes by lenders to allow borrowers to remain in homes without paying could ultimately undermine the very concept of a mortgage: that it is a loan secured by property.  Instead, we risk seeing mortgages turned into another form of unsecured lending, which would raise interest rates for everyone.

Meltzer on Looming Inflation

Allan H. Meltzer, a frequent participant in Cato’s annual monetary conferences, warns in the Wall Street Journal that the Federal Reserve may be about to lay the groundwork for another Great Inflation like we saw in the 1970s:

The Federal Reserve seems determined to make mistakes. First it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes.

Then the press reported rumors about plans to raise the inflation target to 4% or higher, from 2%. This is a major change from the Fed’s quick rejection of a higher target when the International Monetary Fund suggested it a few months ago.

Anyone can make a mistake, but wise people don’t repeat the same one. Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman’s analysis is now a standard teaching of economics. Surely Fed economists understand this….

Yes, a sustained deflation would be a big problem, but it is unlikely in today’s circumstances. Countries with a depreciating exchange rate, an unsustainable budget deficit, and more than $1 trillion of excess monetary reserves are more likely to inflate. That’s our problem today, and it’s another reason the Fed should give up this nonsense about more stimulus and offer a credible long-term program to prevent the next inflation.

Register for Cato’s upcoming monetary conference here. More on inflation risks here and here.

Dollarization Keeps Ecuador Economically Stable Despite Political Instability

Political chaos and institutional meltdowns are all too common in Ecuador’s recent history. A cynic could even interpret yesterday’s violent police uprising that threatened the continuity of President Rafael Correa’s government as “a return to normalcy” in a nation that has had 10 presidents in the last 15 years.

Yet, despite the chaotic nature of its politics, Ecuador has enjoyed relative economic stability since it adopted the U.S. dollar as its official currency on January 9, 2000.

In a country where presidents are regularly toppled by mob protests or popular uprisings, it can be expected that the economy—and particularly the value of its currency—would go into a tailspin with every crisis. This was precisely what happened in the decade prior to 2000, when inflation averaged 37.5% per annum. However, in the 10 years since dollarization, the yearly inflation rate has averaged 6.8%. This number is itself inflated by the fact that inflation reached a peak of 91% in the first year of dollarization, and remained high the following year too. (That initial high rate is explained by the fact that, at the time of adopting the dollar, the government set a particularly high conversion rate for the sucre, Ecuador’s old currency, forcing a massive devaluation that led to high inertial inflation that year.) However, Ecuador’s inflation rate rapidly went down and has largely converged with that of the United States in recent years.

Of course, there are no silver bullets in economic development. Ecuador’s sound monetary policies have not been matched by similar coherent reforms on taxes and spending, or in the areas of trade policy, or labor and business regulations, for example. Ecuador stands in dismal 109th place (out of 141 economies) on economic liberty, according to the latest Economic Freedom of the World report. However, even as their country’s political and democratic institutions constantly fall apart, Ecuadorians can take satisfaction that the value of their currency is not under threat thanks to dollarization.

ARMs as Automatic Stabilizers

An argument often heard for keeping Fannie Mae and Freddie Mac, or some sort of subsidy for mortgages, is the desire to keep the 30 year fixed rate mortgage “affordable.” The 30 year fixed certainly has some merits - which borrowers should be willing to pay for - but it also has the downside of reducing the impact of monetary policy in stabilizing the economy.

Generally interest rates go down in a recession and up in an expansion.  Part of this is the reaction of the Federal Reserve, which tends to cut rates in a recession, but part is also the fact that the demand for credit also declines in a recession and increases in an expansion.

If borrowers moved to adjustable rate mortgages, then in recessions they would likely see a reduction in their mortgage rate, resulting in a reduction in their monthly payment, which would increase their disposable income, which itself should have some positive impact on consumption, helping to stabilize a weak economy.

The reverse would work in an expansion.  If the economy became over-heated, interest rates would likely go up, pushing up monthly payments, resulting in reductions in income and consumption.  While of course this would be unpleasant for the borrower, it would have the benefit of moderating a booming economy, reducing the likelihood of inflation and the occurrence of bubbles.

The latter effect would also increase the degree to which consumers care about inflation and demand price stability from the central bank.  Normally, borrowers have an incentive to favor inflation, as it reduces the real value of their debt.  If however, inflation resulted in an increase in their mortgage rate, their preference could switch toward price stability, which would in the long run be better for growth and the overall economy.

While I do not expect the above to settle the debate over the role of the 30 year fixed rate mortgage, we, as a society, should openly and loudly debate its costs and benefits before we simply assume it needs to be subsidized.

If Not Fannie, then Who?

A common defense offered for keeping Fannie Mae and Freddie Mac, or something like them, is that the market simply cannot absorb the same level of mortgage lending without them.  The central flaw in this argument is that Fannie and Freddie themselves must be funded by the market.  So if the financial markets can absorb X in GSE debt, then the financial markets can absorb X in mortgages.

Different market participants currently face different capital requirements for the same assets.  To some extent, Fannie and Freddie were a vehicle for shifting mortgage risk from higher capitalized institutions to less capitalized.  If the Obama administration and bank regulators are serious about closing “regulatory gaps” then all entities backed by the govt, implicit or otherwise, should hold the same capital against the same risks.  In the following I will thus assume that differences in capital requirements behind mortgages are irrelevant.

So to determine who could absorb the GSEs’ buying of mortgages, let’s look at who holds GSE debt.  Of the approximately $5 trillion in GSE debt and mortgage backed securities (MBS), about a trillion is held by commercial banks and thrifts.  Another trillion is held by insurance companies and pension funds.  Close to a trillion is held by mutual funds.  That quickly gets one to 3 trillion.  Households and state/local governments also hold close to a trillion.  That leaves us with about a trillion left, held mostly by foreign governments (usually central banks).  For this analysis, I am using data pre-Federal Reserve purchases of GSE debt/MBS.

Given that banks hold about a trillion in excess reserves and over 9 trillion in deposits, I think its fair to assume commercial banks could easily absorb another $1 trillion in mortgages, as represented by foreign holders.   Some holders of GSE debt are legally prohibited from holding mortgages.  These entities can generally hold bank commercial paper (think mutual funds) which could then fund the same level of mortgages.  

The point here should be clear, by swapping out GSE debt for mortgages, our financial markets have sufficient capacity to replace Fannie and Freddie.  In fact, we are the only advanced country that does not fund our mortgage market primarily or exclusively with bank deposits.  This analysis also does not assume any reduction in the size of our mortgage market, which should actually be an objective of reform.  We devote too much capital to mortgages, at the expense of more productive sectors of our economy.