Archive for the ‘Finance, Banking & Monetary Policy’ Category
CBO on Fannie, Freddie and Mortgage Finance Options
Just in time for the holidays, the Congressional Budget Office has released its analysis of the costs and benefits of various alternatives to our current system of mortgage finance, particularly the role of Fannie Mae and Freddie Mac.
The report examines three possibilities:
- A hybrid public/private model in which the government provides explicit guarantees on privately issued mortgages or MBSs;
- A fully public model in which a wholly federal entity would guarantee qualifying mortgages or MBSs; or
- A fully private model in which there would be no special federal backing for the secondary mortgage market.
The report doesn’t really push one option over another, but simply lays out the advantages and disadvantages of each. Some highlights worth keeping in mind as the debate continues into the new year:
“Relying on explicit government guarantees…would also have some disadvantages…If competition remained muted, with only a few…firms participating in the secondary market, limiting risk to the overall financial system and avoiding regulatory capture could be difficult…federal guarantees would reduce creditors’ incentive to monitor risk. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices and would most likely end up imposing some cost and risk on taxpayers. In addition, a hybrid approach might not eliminate the frictions that arise between private and public missions.”
“Privatization might provide the strongest incentive for prudent behavior on the part of financial intermediaries by removing the moral hazard that federal guarantees create. By increasing competition in the secondary market, the privatization approach would reduce the market’s reliance on the viability of any one firm. Private markets may also be best positioned to allocate the credit risk and interest rate risk of mortgages efficiently, and they would probably be more innovative than a secondary market dominated by a fully federal agency. Further, privatization would eliminate the tension between public and private purposes inherent in the traditional GSE model.”
It is worth remembering that over the years, the CBO has actually been quite strong in warning against the dangers of the GSE model. Sadly Congress simply chose to ignore those warnings. Here’s hoping that the CBO has little more influence on this issue than they’ve had in the past.
Economic Slack and Inflation
While listening to NPR this morning, I was subjected to yet another economist claiming that we cannot have inflation in an environment of such high economic slack. Setting aside the fact that perhaps this economist missed the 1970s, this is a vital question to examine, because it is the foundation of so much of Bernanke and the Federal Reserve’s current thinking. That is, the notion that inflation is always and everywhere the result of an over-heating, or excess demand, economy.
One of the measures commonly followed by the Fed, and others of the slack-restrains-inflation school, is the measure of capacity utilization rate. Setting aside some of the problems with this measure, are increases in capacity utilization associated with increasing inflation, as would be suggested by the slack-restraint school? It turns out not. Since 1967, when the data series begins, the correlation between capacity utilization and inflation, as measured by the consumer price index (CPI), has been negative. That is, as more and more industrial and economic resources have been brought into use, inflation has actually fallen, rather than risen (as would be predicted). A negative correlation also implies that low or falling capacity utilization does not mean low inflation.
Now what is positively correlated with inflation is the growth in the money supply. The chart below shows annual changes in both CPI and M2. Even just eye-balling the chart, one can see the positive correlation, which also shows up under statistical analysis.
Another question one often hears in today’s economic discussions is what would Milton Friedman say? I won’t claim to be able to channel Milton (or anyone else), but I do think the empirical evidence continues to support the conclusion that inflation is always and everywhere a monetary phenomenon.
Banks Are Lending, but to Whom?
A recurring concern we have heard since the financial crisis erupted is that banks are simply not lending, and that this is holding back economic activity. If only banks would lend, the economy would grow. As usual, the truth is a little more complex.
Unlike in the Great Depression, and despite about 300 bank failures, the balance sheets and deposits of insured commercial banks and thrifts has been steady, if slowly, expanding throughout the financial crisis and recess. Banks have continued lending during this time; however, they have changed who they are lending to. Over the last two years we have witnessed a massive shift from lending to the private sector to lending to the public.
The chart below shows banking business lending and bank holdings of U.S. government securities. The chart suggests that the approximately $500 billion increase in bank lending to Uncle Sam came at the expense of a $400 billion decline in lending to private business. If one assumes that bank balance sheets have either been stable or increased slightly, then a loan to the government must off-set a loan otherwise made somewhere else.
While its hard to exactly measure the job impact of this reduced business lending, some estimates have been made on the impact of SBA lending. According to one study, every $41,600 in new small business loans is associated with 1 new job created. While this number should be taken with a grain of salt, it implies that the $400 billion reduction in business lending has cost over 9 million jobs. Of course, one might argue that the half-trillion in lending to the govt has created or “saved” some jobs. Accepting the difficulty of coming up with a reliable estimate, I think its fair to say that on net a few million jobs have been lost due to this shift of lending from the private to the public sector.
Also of interest is that since the financial crisis, and despite the failures of Fannie and Freddie, commercial banks and thrifts have increased their holdings of Fannie/Freddie/Ginnie securities by over $300 billion.
Textbook economics usually teaches that government crowding out of private investment only really occurs when we are near full-employment. Yet looking at the balance sheets of our commercial banks and thrifts, would suggest that U.S. Treasuries and Agency securities have crowded out significant lending that would otherwise go to the private sector. But this should come as no surprise, since banks can borrow for close to zero and invest risk-free in government debt, earning a nice spread of 3 to 4 percentage points.
Is the Federal Reserve Heading Towards Insolvency?
A recent statement from the Shadow Financial Regulatory Committee, points out that both rounds of quantitative easing by the Federal Reserve have dramatically altered the maturity structure of the Fed’s balance sheet. Normally the Fed conducts monetary policy using short-term Treasury bills, which allows the Fed to avoid most interest rate risk. In loading up its balance sheet with long-dated Treasuries and mortgage-backed securities, the Fed has exposed itself to significant interest rate risk.
Recall that the yield, or interest rate, on a long term asset is inversely related to its price. So if you’re holding a mortgage that yields 5% and rates go up to 6%, then the value of that mortgage falls below par. The same holds for Treasury securities. I think it is a safe assumption that rates will be higher at some point in the future. When they finally do rise, and if the Fed still maintains a large balance sheet of long-dated assets, those assets will suffer losses.
Of course the Fed is not subject to mark-to-market rules and can avoid admitting losses by holding these assets to maturity. But if the Fed, at some point in the future, wants to fight inflation, the most obvious way of doing so would be to sell off assets from its balance sheet. It is hard to see the Fed engaging in substantial open-market operations without using its long-dated assets. But if it is to sell these assets, it will have to do so at a loss (once again, because of higher rates).
Now the Fed claims to have other avenues by which to tighten, besides open-market operations. For instance, it can raise the interest rate on excess reserves. But then this would further erode the value of assets on its balance sheet. Not to mention that they have to find the money somewhere to pay these higher rates on reserves.
Ultimately the Fed can continue to pay its bills, not out of earnings from its balance sheet, but by electronically crediting the accounts of its vendors and employees, but that would also be inflationary. The real danger, again pointed out by the Shadow Committee, is that the Fed may avoid raising rates in order to minimize the losses embedded in its balance sheet. One of the very real dangers from QE1 and QE2 is that the Fed has exposed itself to potential losses that are correlated with any efforts to fight inflation, raising serious questions as to its willingness to fight inflation.
Take Your Stinking Paws Off My Benjamins You Damn Dirty Statist
Okay, perhaps the title of this post is not quite as memorable as Charlton Heston’s famous line from Planet of the Apes, but it certainly captures my sentiments after reading an article in Slate that calls for the elimination of the $100 bill. The author, Timothy Noah, says that large bills are only for “criminals and sociopaths.” Here’s the crux of his argument.
…why does the U.S. continue to print C-notes…? Technological change has reduced much further the plausible need of any law-abiding American to carry a C-note in his wallet or to stash a pile of C-notes in his mattress.
Noah’s argument is unconvincing for several reasons. First, he is underestimating the degree to which “law-abiding” Americans use “Benjamins.” And with higher inflation almost certainly around the corner, one can safely expect that $100 bills will become even more common in the future. Second, his entire argument rests on the statist assumption that government should restrict honest people because this will somehow make life more difficult for criminals. Yet he debunks his own anti-money laundering argument by noting that the government already has stopped printing larger bills, such as the $500 note. Has that stopped the drug trade? Hello? Anyone? Bueller?
Like much of what government does, the campaign against money laundering is a costly exercise with very few tangible benefits. This video examines the cost-benefit issues.
I actually think the moral arguments against anti-money laundering laws are even more powerful. As Americans, we should have a presumption of innocence in our daily lives. What business is it of government whether we want to carry $20 bills or $100 bills? And think about the implications of these laws. What if the government said we need to ban cars, or put government-monitored homing devices in all vehicles, because bank robbers occasionally use automobiles as getaway vehicles? In this case, there is a theoretical benefit to the policy, just like there is a somewhat plausible case for anti-money laundering laws, but presumably we would reject such a policy as too intrusive.
Anti-money laundering laws are a classic case of bad policy leading to more bad policy. The government passes drug laws that create huge profits for criminals. But rather than getting rid of victimless crimes, the government imposes policies that make life more difficult and costly for everyone else.
Is There an Inflation-Unemployment Trade-off?
Much of what drives the policy choices of Ben Bernanke and the Federal Reserve is a belief in the ability to trade higher inflation for lower unemployment, known within the economics profession as the “Phillips curve.” But does this trade-off actually exist?
While its true that many have found a negative correlation between inflation and unemployment prior to 1960, looking at U.S. data, this relationship appears to have broken down in the mid-1960s, just about the time policy-makers thought they could exploit it (Lucas critique anyone?).
It is hard, looking at the graph, which displays the annual change in consumer prices over the previous year and unemployment, to see much of a relationship. In fact, since 1960, the correlation between changes in CPI and unemployment has been positive. We have generally seen rising unemployment along with rising inflation. Of course, one might be concerned that the stagflation of the 1970s is driving this result. But looking at the data since 1980, there still remains a positive correlation between inflation and unemployment. While I am not arguing that inflation causes unemployment (after all, correlation is not causation), it should be clear from the data that there is not some exploitable trade-off that policymakers get to choose.
The Richmond Fed also has a great history of the Phillips curve that is well worth the read. Perhaps Fed President Jeff Lacker should bring copies to the next FOMC meeting.
Advocates Complain Banks Not Putting FHA at Enough Risk
A constant narrative of the financial crisis is that banks out-smarted the government by taking excessive risks, and that if only we had empowered regulators, the whole crisis would have been avoided. The truth, however, is that government was often the driver of excessive risk-taking, and nowhere is that more true than in the mortgage market.
One of the worst offenders has been the Federal Housing Administration (FHA). Even today, one can get an FHA backed loan with only a 3.5% downpayment. After the financing of seller concessions, the borrower can leave the closing table with zero, or even negative, equity. FHA will even offer these low equity loans to subprime borrowers, those with the worst credit history. If there’s anything to be learned from the financial crisis, combining high risk borrowers with low downpayment loans is asking for default.
Despite FHA’s loose standards, several lenders have responsibly chosen to impose higher underwriting standards than FHA. Sadly instead of being praised for being slightly more responsible than FHA, these lenders are being attacked by so-called consumer advocates for not taking enough risk.
The Washington Post reports that a coalition of advocates is planning to file complaints against lenders who have higher standards than FHA, claiming that higher standards discriminate against minorities, since minorities on average have lower credit scores. It seems some have learned nothing, continuing to push the very same policies that contributed to the crisis. If anything, FHA should start moving in the direction of the more responsible lenders and improve its woefully weak underwriting standards. Congress should also move in the direction of requiring meaningful downpayments on FHA loans, as well as shifting some of the credit risk back to the lender.
Boehner to Protect the Fed?
With Republicans taking control of the House in January, long-time Federal Reserve critic Rep. Ron Paul is in line to take over chairmanship of the House Financial Service Committee’s Subcommittee on Domestic Monetary Policy and Technology. This is the subcommittee with direct oversight of the Federal Reserve.
The thought of having some actual oversight of the Fed is apparently making Wall Street and the rest of the banking industry nervous. Recent disclosures of Fed lending to foreign banks and Wall Street did not help the public image of either Wall Street or the Fed. With Congressman Paul pushing for a full audit of the Fed, it is likely even dirtier secrets of the Fed may come to light.
So where have the Fed and Wall Street turned for protection? According to Bloomberg, the Fed’s new protector might be incoming House Speaker John Boehner. Next week, House Republicans meet to select their committee and subcommittee chairs. Bloomberg sources report that, at the request of the major banks, Boehner is looking for avenues to either deny Paul that subcommittee chair or to restrict his ability to oversee the Fed.
While I always expected the House Republicans to eventually revert back to their old ways, I did think they’d at least wait until 2011. I believe this will be a real test of Boehner: Does he choose to rein in Ron Paul or rein in the Federal Reserve?
Robert H. Frank’s Non-argument for Higher Tax Rates
In The New York Times, Robert H. Frank of Cornell University repeated his perpetual argument that high tax rates on the rich do no harm to demand (not supply) because the rich can just draw down savings, year after year, to pay more taxes yet maintain a showy lifestyle. Then he resorts to the old trick of asserting there is no “credible” evidence that tax disincentives and distortions have any ill effects on the economy.
Frank asks, rhetorically, if an increase in top tax rates might reduce economic growth. And he replies, “There’s no credible evidence that it would.” This is a timeworn trick among people too intellectually lazy to look for a single academic study or statistical fact.
As I have shown before, Mr. Frank has a history of abusing bogus statistics culled from dubious sources.
To simply assert “there’s no credible evidence,” however, is much worse than distorting the facts.
It amounts to claiming that he has the ability and the right to suppress facts not to his liking.
Over the past year I have repeatedly cited several major studies showing that pushing the highest marginal tax rates even higher is extremely dangerous to economic growth; Stanford economist Michael Boskin lists half a dozen of them in his latest Wall Street Journal op-ed.
For Mr. Frank to assert that such studies are not “credible” simply reveals his own inability to find credible evidence to support his own untenable position.
David Wessel’s Curious Defense of the Fed’s Ambiguous Mandate
David Wessel, the Wall Street Journal’s economics editor, appears displeased that Republican Congressmen Bob Corker, Paul Ryan and Mike Pence want to clarify the Federal Reserve’s mandate – instructing the Fed to focus on preserving the value of its Federal Reserve notes, rather than continuing the 1946 Employment Act’s instruction to also “maximize employment” and minimize long-term interest rates (he mistakenly refers to this as “reopening the Federal Reserve Act,” which included no mandate). Wessel imagines this must be a political stunt, citing some seemingly sensible comments by Sarah Palin as evidence. He cannot imagine any valid reason for a prudent backlash against Chairman Bernanke’s repeated references to the dual mandate as an excuse for trying to nudge inflation higher.
Instead of looking ahead, Wessel looks back — selectively. He writes, “prices rose at only a 1% annual rate in the third quarter, the Commerce Department said Tuesday.” However, that figure refers only to personal consumption expenditures (PCE), not to inflation in the overall economy, including producer prices. The implicit price deflator for GDP rose by less than 1% in 2009, then at a 1.1% rate in the first quarter, 1.9% in the second and 2.3% in the third. That is insufficient evidence of a worrisome trend, but it is also insufficient evidence to justify a massive program of monetizing long-term Treasury bonds.
Since QE2, Wessel notes, “markets have confounded the Fed by pushing yields on 10-year Treasuries up lately” [to about 2.9% from 2.5%]. I hate say “I told you so,” but I told you so.
Wessel counters that, “No measure of inflation expectations foresees anything like the 8%-plus inflation of the ’70s.” Of course not. If markets expected inflation above 8% then bond yields would already be above 8%. But expected inflation never makes a sudden leap from 3% to 8% overnight, and expectations are often slow to catch up to reality.
In 1972, no measure of inflation expectations provided advance warning of the 7.9% rise in the core PCE deflator in 2004 (10.4% including food and energy). In 1978, no measure of inflation expectations provided advance warning of the 9.2% rise in the core PCE deflator in 1980 (10.7% including food and energy). Inflation creeps before it gallops. Yet inflation surprises commonly result in falling bond prices and falling real wages, which means expectations proved overly optimistic.
Mr. Wessel’s new book is called, “In Fed We Trust.” Such ardent faith has often been misplaced.
The Fed’s Impossible Mandate
The Federal Reserve’s longstanding statutory role is an impossible one, according to Cato Institute Senior Fellow Gerald P. O’Driscoll, Jr., and it’s time for it to end. We discussed the “dual mandate” in today’s Cato Daily Podcast (Subscribe via RSS and iTunes):
Fed Can’t Serve Two Masters
Last week Congressman Pence and Senator Corker announced a bill to end the Federal Reserve’s dual mandate of price stability and maximum employment. Before getting into why this is a good start, what exactly is the dual mandate? Section 2a of the Federal Reserve Act, which sets the Fed’s monetary policy objectives, directs the Fed to:
maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Building upon the notion of the Phillips curve, which suggests an historical relation between inflation and unemployment, some have read 2a as implying that the Fed should pick an inflation-unemployment trade-off that improves social welfare. It is this perceived “trade-off” that dominates the current actions of the Federal Reserve. Quite simply, Fed leaders, such as Bernanke, believe with a little extra inflation we can get more employment.
The problem is that this isn’t so. As soon as policymakers tried to exploit this trade-off, in the 1960s and 1970s, it disappeared. From about 1961 to 1966, it did indeed appear that one could choose a mix of inflation and unemployment. But from 1966 until 1980, when Volcker moved to bring down inflation, inflation and unemployment were positively correlated. It appeared that all we got was more inflation and more unemployment.
Despite the painful experiences of the 1970s, Bernanke seems intent on repeating those mistakes. Which gets to me to the point of removing the dual mandate. It forces the Fed to focus on the only thing it really has any influence over: inflation. It also removes the temptation to exploit an inflation-unemployment trade-off that never existed in the first place.
Now given Bernanke’s views on price stability, eliminating the dual mandate can only be a first step. We ultimately need to remove the discretion of the government to indulge in the Phillips curve fantasy.
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