Topic: Finance, Banking & Monetary Policy

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.

Recession Over?

As an economist I am the first to admit that sometimes the methods and practices of economics can end up creating confusion rather than understanding.  The National Bureau of Economic Research’s (NBER) recent announcement that the recession ended in June 2009 is one such example.

At the heart of this confusion is a difference in how the public sees a recession and how NBER defines it.  Most importantly, NBER views recessions as contractions.   Simply, “Is the economy growing or not?”  NBER uses that framework to then date business cycles from their peak to their trough.  For this reason, NBER will often date the beginning of a recession during a time when the economy feels strong (at its peak) and date the end of a recession when it feels weak (when it’s at the bottom).

Since this method seems at odds with how the public views the economy, why do economists use it?  Quite simply, it is a lot easier to spot, and agree on, turning points in the economy than it is to agree on when growth moves from weak to moderate to strong.

OK, enough on definitions.  Did we actually hit bottom in Summer 2009?  Looking at a variety of economic measures, I think it’s clear we hit bottom earlier–more like Spring 2009.  Again, I must emphasize: Hitting bottom is not the same thing as “everything is fine” - just ask anyone who’s personally hit bottom.  Just two examples of why I believe the contraction ended in early 2009; first: consumption, as one can see from the chart, actually hit bottom hear the end of 2008.

One of the defining characteristics of the current recession has been continued weakness in the labor market.  I would go as far as to say there has almost been a disconnect of the labor market from the general economy.  All that said, looking at the trend in layoffs and discharges indicates that separations from the labor force peaked near the end of 2008.  The graph below also illustrates why some are worried about a double-dip, as layoffs spiked again in the middle of 2010, although most of that is driven by the 2010 Census hires.

The point to all this is not to argue that the economy isn’t weak.  It obviously still is.  However, the economy has been growing, for at least a year, and under many measures, longer.  Interestingly enough, most measures of the economy hit bottom before a dime of stimulus money was spent.  The above charts are from the Federal Reserve of St. Louis FRED website.  Don’t take my word on these two charts.  Look at lots of other measures.  Not all, but most other measures seem to tell the same story.

Obama’s Wants a 23.9% Capital Gains Tax, but the Rate Actually Will Be Much Higher Because of Inflation

Thanks to the Obamacare legislation, we already know there will be a new 3.9 percent payroll tax on all investment income earned by so-called rich taxpayers beginning in 2013. And the capital gains tax rate will jump to 20 percent next year if the President gets his way. This sounds bad (and it is), but the news is even worse than you think. Here’s a new video from the Center for Freedom and Prosperity that exposes the atrociously unfair practice of imposing this levy on inflationary gains.

The mini-documentary uses a simple but powerful example of what happens to an investor who bought an asset 10 years ago for $5,000 and sold it this year for $6,000. The IRS will want 15 percent of the $1,000 gain (Obama wants the tax burden on capital gains to climb to 23.9 percent, but that’s a separate issue). Some people may think that a 15 percent tax is reasonable, but how many of those people understand that inflation during the past 10 years was more than 27 percent, and $6,000 today is actually worth only about $4,700 after adjusting for the falling value of the dollar? I’m not a math genius, but if the government imposes a $150 tax (15 percent of $1,000) on an investor who lost nearly $300 ($5,000 became $4,700), that translates into an infinite tax rate. And if Obama pushed the tax rate to almost 24 percent, that infinite tax rate gets…um…even more infinite.

The right capital gains tax, of course, is zero.

China Currency Hearings a Distraction

This week’s congressional hearings on China’s currency generated a lot of heat but almost no light. Winning the prize among tough competition for the most irresponsible sound bite was Sen. Charles Schumer, D-N.Y. At a Senate hearing Thursday that featured Treasury Secretary Tim Geithner, Schumer tossed out this grenade:

At a time when the U.S. economy is trying to pick itself up off the ground, China’s currency manipulation is like a boot to the throat of our recovery. This administration refuses to try and take that boot off our neck.

The implication of the senator’s remark is that Americans would be enjoying a robust economic recovery right now if only China were to allow its currency to appreciate by 20 to 40 percent. But is that a reasonable charge?

Granted, China’s currency, the yuan, probably is priced in dollars below what it would be were its value freely determined in global currency markets. And an undervalued currency will make Chinese imports to the United States more affordable, and U.S. exports to China somewhat more expensive. But “a boot to the throat of our recovery”? Let’s get real.

The Chinese market has been one of the bright spots for American exporters. China’s economic growth has been so robust that its growing demand for U.S. goods has swamped any negative effect of its currency. In the first seven months of 2010, according to the most recent monthly report from the U.S. Commerce Department, exports of U.S. goods to China are up 36 percent compared to the same period last year. That is a 50 percent faster growth rate than U.S. exports to the rest of the world.

Meanwhile, U.S. imports from China so far this year have been growing more slowly than exports to China, and more slowly than imports from the rest of the world. As a result, while our trade deficit with China in 2010 has grown by $22 billion, our trade deficit with the rest of the world has grown by $64 billion. But it is much easier these days to demonize China than other trading partners with whom Americans run a trade deficit, such as Canada, Japan, and the European Union.

One of the bright spots of the U.S. economy has been the manufacturing sector, which is supposedly taking the brunt of China’s “currency manipulation.” According to the latest report from the Federal Reserve, U.S. manufacturing output is up about 8 percent from a year ago.

The chief obstacle to America’s recovery is not China’s currency regime, but a housing market that remains depressed, soaring government spending and debt, looming tax increases, and grandstanding politicians who refuse to remove those very large boots from the neck of the American economy.