• Asset price inflation (at least initially) as opposed to broader price inflation.
• A massive increase in leverage (debt to magnify returns) throughout the financial system and our economy.
• A massive increase in the size of the financial sector relative to the rest of the economy. Since it is built on leverage, financial sector compensation has soared and led to concentration of wealth in financial hands.

The last fascinates me, as a sector which should be a relatively small part of the economy functioning as intermediaries has through leverage achieved profits (a redistribution of wealth from the rest of our citizenry) far from the size their intermediary function can possibly justify. These intermediaries for example accounted for about a third of the market capitalization of the S&P 500 before they crashed and burned. How do the intermediaries deserve a market cap that amounts to around half of those for whom they intermediate?

The answer is increased leverage. I’ll address this in more detail later, but the Federal Reserve has finally decided to expand the monetary base, which has consistently grown at a very slow, or non existent rate. From David Merkel:

Check out the very far left side of the graph and look at the vertical takeoff.

David fills us in on the details:

Look at the H.4.1 report.  We may have finally hit the panic phase of monetary policy, where the Fed increases the monetary base dramatically.  They are pumping the “high-powered” money into loans:

• $20 billion for Primary credit
• $80 billion for Primary dealer and other broker-dealer credit
• $70 billion for Asset-backed commercial paper money market mutual fund liquidity facility
• $40 billion for Other credit extensions
• $80 billion for Other Federal Reserve assets
• -$20 billion netting out other entries

Making it an increase of roughly $270 billion from last week’s average to Wednesday’s daily balance.  Astounding.

In general, the increases are not being pumped into the banks, but into specialized programs to add liquidity to the lending markets.  Now, I’ve written about this before, but it bears repeating.  What happens if the Fed takes losses on lending programs.  It reduces the seniorage profits that they pay to the Treasury, which means the Treasury has to tax or borrow that much more.  The Fed isn’t magic; it’s a quasi-extension of the US Government in a fiat currency environment.  It’s balance sheet is tied to the US Treasury.

Yves Smith at Naked Capitalism is correct.  The US is no longer a AAA credit, particularly if you measure in terms of future purchasing power of US dollars.  I’ve felt that for years, though, with all of the unfunded future promises that the US Government has made with Medicare, Social Security, etc.  The credit of the US Government hinges on foreign creditors (like OPEC and China) to keep it going.  What will they offer them? The national parks?

True, all true, but possibly if they are going to provide monetary stimulus this might be a better way than cutting rates, now and in the future.

Technorati Tags debt crisis, Federal Reserve, leverage, monetray policy, Treasury

Earlier this year, Mr. Bush derided a modest plan to provide $4 billion to states and localities to buy foreclosed properties, saying that buying up empty homes helps only “the lenders or the speculators.” Actually, it protects entire neighborhoods and local economies from the effects of foreclosures by preventing a greater buildup of unsold homes and a further drop in prices.

This site is not about politics, but before I discuss this some disclosure is necessary. I am a fan of free markets. I do not however belong to that group of fans who believes that the market left to its own devices comes up with an optimal outcome (however one might define optimal.) There are a number of reasons to favor free markets, that isn’t one of them.

Still, one reason to favor markets, and all the pain and inequity they come with, is that even if one believes that well thought out policies could cure whatever evils (however one wishes to define them) that the market (or our world in general) afflicts us with, it is highly unlikely that we will ever get such policies. This kind of solution is exhibit 10,549 of that truth.

I only address the politics of this, because as investors we are forced to analyze things which will undoubtedly rub some peoples political beliefs the wrong way, and this is one place where I cannot avoid it, no matter how much I might wish to do so.

The absurdities

So what exactly have our leaders in Washington, and pundits on the board of the Times, come up with?

First let us deal with the absurd aspects of this plan. The government buys up a bunch of foreclosed properties that are theoretically driving down the prices of other homes. Uh, does anyone else see the big gaping hole in this logic? After the government buys them, they are still abandoned! Unless the government just takes them off the market indefinitely (thus restricting supply) rather than sell them, how does that solve the problem of excess inventory?

What it does do is allow the lenders to get a price higher than they would if the homes had to sell at a price that people could actually afford. So, bankers and other lenders get bailed out, taxpayers have a bunch of homes they have to sell at prices lower than they paid for them. Personally, I would rather have our taxes not be used to bail out lenders.

One problem homeowners are facing is abandoned homes becoming a drag due to lack of maintenance. Will the government keep all these homes up? As little faith as I have in the lenders, the profit motive will likely make them better stewards (if only marginally, given the enormity of the issue) than the state.

A Little Reality

Most important, is that we investors need to avoid falling for simple sounding solutions that will in the end not help that much. The ultimate problem with housing is not greedy lenders (greed is nothing new) or deadbeats, government policies (a personal favorite post of mine) or incompetent regulators (though all had their role in getting us to this point.) It is that housing prices are too high.

For reasons stated above this particular solution is not going to help keep prices high, but what if they could? Is that really good? Housing is extremely unaffordable in many markets. Prices will come down. Is dragging that out the best answer? I find that in isolation a dubious, and at best a marginal, good. Given the cost, in tax dollars, inflation, misallocation of resources and the moral hazard of lenders and borrowers believing that risk can be taken with some portion of it underwritten by the state, the benefits should have to be huge. As investors we should be skeptical that the end result will be good for the rest of the economy.

The same problem comes even with trying to keep interest rates low. Let us assume that these various measures, combined with low interest rates, slows, or even temporarily halts, the decline in housing prices.

Much as with claims about the “fed model” there is the belief that lower interest rates will allow people to afford a home that they could not a higher rate, ( also that lower prices will result in demand curves that shift) etc. All of these arguments miss a key point. Interest rates change. A stock price that is “justified” by todays interest rate, says nothing about whether it will be similarly “justified” in the future. Nor does a high price being “justified” by low current interest rates mean you will get a satisfactory return. It just means it will be better (actually that isn’t a given either) than a bond yielding 3% (or whatever the low rate happens to be.)

So it is with housing. Absent a speculative bubble such as we just went through in housing, low interest rates might encourage people back into the market. It might halt the slide in housing prices from going back to an economically reasonable level as fast, or temporarily. However, those buyers will not be selling to people with similarly low rates in the future. In an efficient market (stop giggling Barry and Jeremy) markets would see through temporary low rate periods and price housing at sustainable levels that vary little around interest rates. I suspect in this instance gun shy homeowners will (or even lower.) At the end of the day however it doesn’t matter even if they do not. All that means is that down the road prices will fall when interest rates go up and prospective buyers cannot afford them any longer. The same for being able to “afford” a house at a lower credit score. Prices still have to be affordable for succeeding groups of home buyers. In much of the country they just are not. This not just “gonzo” pundits beating some fantasy bear drum, but yes Jeff, “real” economists such as Martin Feldstein (who has some trenchant comments on the health of the economy and misreading of the GDP data as well)

I’ll tell you what worries me. We saw house prices overshoot by 60% relative to costs of building and relative to rents. And I worry about the possibility that they will keep falling; they will spiral downwards. In the same way that they went much too high, they could go much too low. And if that happens, then we are going to see individuals feeling a lot poorer, cutting back on their spending, defaulting on mortgages, and we’re going to see the holders of those mortgages see their assets, their capital being cut and therefore their ability to make loans being cut.

Incoherence

Bill Gross should know better, but unfortunately he doesn’t seem to realize that after decrying the destructive potential of housing prices rising faster than inflation and incomes, that keeping them from correcting that rise is destructive as well, and unlikely to work.

So let us end with one more political (if non partisan) note. If all these policies could help keep prices up, if other policies suggested are effective as well, what have we done?

Encouraging people to buy houses at prices that were economically too burdensome, and likely to eventually lose value, is what got us into this mess in the first place.

Why is it a virtue for the government to do exactly what we are criticizing mortgage companies, banks and even the fed for encouraging home buyers to do in the past? Isn’t the end result just the same thing if possibly a bit more drawn out? Investors beware.

Update: Dean Baker (another “real” economist) takes up some similar themes:

Have the NYT editorial writers not noticed this bubble or do they think the housing bubble was a good development that the government should try to foster?

The level of incoherence of the housing policy advocated by the NYT is astounding. Why on earth should Congress act to keep house prices above their market level?

House price supports will not work in the long-run. If we keep house prices high, builders will construct more houses and the over-supply will grow even larger. In this way, a house price support program is like a farm price support program, except we have a $20 trillion stock of housing. The market for most farm products is in the tens of billions of dollars annually.

A house price support program will end up costing the government billions and possibly tens of billions of dollars. Is it better for the government to spend this money (most of which will be paid to banks) supporting house prices than to pay for health care, child care or good rental housing?

Furthermore, since house prices will eventually fall to their market clearing levels, will the NYT policy even help moderate income homeowners? They will be paying far more in housing costs for the years they still in their home than they would to rent a comparable unit. This will be diverting money that they may have otherwise used for their kids health care and child care or other necessary expenses. And, since the house price will fall, they will never accumulate any equity.

Jon Henke also smells the whiff of the farm support program.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags housing, interest rates, Martin Feldstein, media, New York Times

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

Read the whole thing, but it mirrors much of what we have been saying. Here is Martin on the Charlie Rose show where he stresses that it is not just a subprime issue, that all kinds of assets were not priced appropriately, and frankly still are not:

Hat Tip: Barry Ritholtz

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags Charlie Rose, credit markets, Economics, fiscal policy, Martin Feldstein, monetary policy, NBER, Risk, the economy

The crux of his argument is this:

So if the massive run-up in house prices since 1997 was a bubble and if the bubble has now been popped we should see a massive drop in prices. But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average (see chart in the extension). Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007).

Except the argument has never been that prices would decrease immediately or quickly. The consensus of those of us who have worried about this has been that it would be a transition which would take years. Housing doesn’t correct quickly as a rule.

Alex feels the market has shifted to a new higher equilibrium:

If we don’t see the massive drop back to “normal” levels then the run up in prices should be described as a shift to a new equilibrium – much as happened during World War II – see the chart. (It’s an important question to ask what changed and why?). In the shift to the new equilibrium there was some mild overshooting, especially due to the subprime over expansion, but fundamentally there was no housing bubble.

I actually agree that in some markets we may see a new higher equilibrium, say California, but it will take a large drop first. Here is the chart showing price declines from above, but updated to reflect recent declines (Alex’s chart is old)

Frankly, those are some pretty scary declines, and now they are across the board, not just the hottest markets. This chart isn’t adjusted for inflation however, so the declines are happening in close to real terms, while the increase is merely nominal, making the increase seem more dramatic and the declines less so than they are.

In my mind real prices (that is prices adjusted for inflation) will fall at least another 25% on average, with nominal prices not seeming to fall as much, as inflation over the next few years eats into it. I suspect we will see a great deal of this fall come from stagnating nominal prices with inflation catching people up. I hope so at least. Too rapid a fall would make it more difficult for people, and the financial markets, to digest.

What about that new equilibrium? Megan McCardle discusses this issue:

What bothers me is that I don’t understand why we should have shifted to a new equilibrium. I think I understand the reasons that the equilibrium values shifted between 1940 and 1950:

• Developments in rail and construction techniques in the 1910-20 brought huge amounts of land under development, and pushed urban buildings rapidly upward, at a time when population growth was slowing, depressing prices
• The Great Depression kept them low
• This massive pent up demand translated into a boom in housing demands as incomes recovered
• The FHA, and then the Veterans administration, basically introduced an entirely new product: the long term amortizing mortgage. Previously, mortgages had been short-term affairs with balloon payments at the end; five years was a very standard term. The long-term amortizing mortgage, especially when helped along with government subsidies, massively increased the amount a couple could pay for their house.
• Housing demand was then sustained by high rates of real economic growth and population growth, which caused housing demand to skyrocket.
• Prices leveled off as the automobile brought new land into housing, but since the mortgages kept demand pegged to incomes, they never actually fell
• The post-1970 fluctuations are money illusion, responses to changes in nominal interest rates.

I find it hard to name a comparable equilibrium changing development in 1997.

The reason I am willing to think that it may happen to some extent is that in looking at the first chart one notices that markets with constrained available housing supply rose the fastest. Most of these cities have restricted the ability of the market to supply housing. Absent those restrictions the increases would have likely been more along the lines of Dallas and other cities which have the lowest rise. Megan makes that her one caveat as well:

I am fairly well convinced Ed Glaeser’s argument that high coastal real estate prices are due at least in part to the fact that local interests are increasingly effective at blocking new development. But that’s been going on for decades; it didn’t suddenly change in 1997.

Given that the largest increases occurred in just the kind of areas where Glaser says they should, it does give Tyler’s view credence. While I am willing to entertain the possibility, I find it very questionable. It is instead to me more likely to be one of the driving forces behind the bubble, not an explanation for why there wasn’t one.

While Shiller’s charts show the kind of rise which should give us all pause, they don’t actually get at the heart of the matter, which is affordability. Housing has to be affordable. If one looks at the cost of owning a home versus income, the rates are really scary, especially in the markets we look at above. While a lack of land or other restrictions can increase the cost of housing in the short run, and certainly were part of the story here (that is simple supply and demand) long term it likely doesn’t matter, and I suspect it will not establish a much higher equilibrium even in those types of markets.

Why? Because people can move. The US has abundant land, even around its major cities. We have only urbanized (including suburbs and exurbs) only about 3% of our land mass. People were willing to pay above average amounts for housing in places where housing has been restricted because they felt they were profiting from the rise. People will probably not go on paying 5 to 10 times income if they stop believing that appreciation will bail them out. The housing bubble gained momentum in these areas because of the restrictions, then speculation drove the price far beyond what could reasonably be carried. Now that process is in reverse. The likely outcome is that housing will go back to being a fairly tight band around 3-4 times local income on a national basis. This arbitrage between high housing cost and lower housing cost areas will slowly work that excess out. Possibly over decades.

Some have claimed that lower cost mortgages that people took out in the past will allow them to permanently keep a higher value on their home. That doesn’t work. The housing markets prices are set at the margin. It is buyers and sellers of homes who set the prices, not people who have homes that due to past low interest rates can afford to stay in their existing homes. New mortgages are the issue, not those already in place. Besides, housing prices in many of these areas were already unaffordable before the dramatic drop in interest rates. Without the promise of appreciation and the equity gains they led to, they are no longer affordable regardless of when they took out their mortgage. To afford the home, many took out home equity loans to live. Now they do not have that option.

Worse, we could see over shooting to the down side. The credit debacle (which extends far past subprime, one of the key errors has been seeing it as just a subprime, or even housing, issue) could make this unravel faster than I expect and lead to areas which did not participate in the bubble suffering right along with everybody else. The declines due to a reversal of speculation could therefore lead to even lower prices.

I would say there is a bright spot to all this. Housing needs to be more affordable. The adjustment will be painful, but in the long run prices, especially on a key consumption good such as a home, would serve us better not to go up faster than inflation. I have long been arguing that governments who restrict housing and make it less affordable should not be bragging about rising property values. Not only is it a hardship for most people, but it makes the housing market more volatile, as this year is making clear. It is not because they have made their communities more attractive. It is decreased supply, not increased demand, that is the primary driver of the increase.

In our firm we have been harping on this long before it started to show itself. It is going at about the pace we expected, if not a bit faster. So Alex, as often as we agree, I have to part ways with you on this one. We have a bubble.

Other views: Institutional Economics, The View From Alexandria, Urban Planning Blog, Paul Krugman, Kevin Drum, Ross Douthat, Alex Whalen, The Glittering Eye, Fester, Housing Derivatives, David Merkel

Update: Those interested in the link between land use and construction regulations and housing costs might enjoy this link on new research out of Seattle showing the impact of housing regulations on the cost of housing.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags Alex Tabarrok, bubble, Economics, housing, Robert Shiller, subprime

What does this mean for investors. Quite a number of things – none of which are particularly good over the long term:

1) Why Cut today? What was the motivation for today’s cut? Would waiting 7 days have done anything. other than allowing some of the excesses to get wrung out of the system?

2) Equity Market Dysfunction? Is it that the equity markets are not working properly? Likely not. Are rates too high? I doubt that’s the reason for any of our economic woes. Then what is it – are lowered equity prices a problem?

Globally, equity markets have been in the process of “Repricing Risk” – why is the Fed disrupting that? Further, there is now a recognition that S&P500 earnings were priced way too high – especially in the event of a European and Asian slow down. That lowered “E” in the P/E adjustment is also under way.

3) TANSTAAFL: The free lunch crowd (a/k/a Long & Wrong) has been chanting for Fed cuts. However, these are not with0out consequences, as Inflation remains a pernicious threat.

Here’s a question: What goes to $5 a gallon first – Milk or Gasoline? How about $6?

4) How Independent is the Fed? The Fed is supposed to be an independent entity, whose mission is a) price stability (inflation) and b) maximizing employment (growth).

However, today’s action reveals an apparent third obligatory goal – protecting investors and market prices. I had no idea that back-stopping speculators and hedge funds was part of their mandate…

5) Capitulation? The Market gapped 400 points, and is now climbing higher (off 300 as I type this). My second biggest concern is that the Fed merely delayed the inevitable. This market saving cut prevented a thorough, 5% wash out. In other words, all the Fed did was prevent a healthy capitulation.

6) Pushing on a String? My biggest fear is that we close down 500 points anyway. That would be the worst of all worlds: A compromised, political Fed, working on behalf of speculators, to the detriment of ordinary taxpayers, is proven to be a paper tiger. That scenario would but the “F” in Fugly.

7) Decoupling US Equities from Global Slowdown? Other markets were down much more than the US. But that makes sense, seeing as they have been a whole lot more than the US over the past 5 years . . .

Bill Gross echoes Barry and I:

“It’s a sad testament to think the Fed has to cut interest rates eight days in front of a meeting to salvage the equity markets. The U.S. economy is in a rather sad state of affairs in that it depends on housing and stock prices to keep going.”

-Bill Gross, founder and chief investment officer, Pacific Investment Management Co. (PIMCO)

Paul Desmond in the Wall Street Journal builds on the theme:

In many ways, this is what a classic bear market looks like: After a long period of exuberance, a downturn hits one part of the economy — in this case, the housing market and mortgage-backed securities. Eventually, that leads to broader losses, even for strong companies, and markets begin a prolonged grind downward. . .

The current market looks a lot like the beginning of past bear markets, such as the ones that began in 2000 and in the 1970s and 1987, said Paul Desmond, president of market-research firm Lowry’s Reports in North Palm Beach, Fla. First, the most troubled stocks decline — home builders and financial stocks in the current case — and then others gradually get hit, including small stocks, retailers, technology stocks, and foreign stocks. Finally even stocks of strong companies are affected.

What happens, Mr. Desmond says, is that trading volume and price movement get heavier and heavier for stocks that are declining, and lighter and lighter on the buying side, as more investors look for a way out. When the selling reaches a climax, the bear market is nearing an end, but Mr. Desmond says he doesn’t see any sign of a climax yet.

“We feel we have been in a bear market since July. Everything that we have seen since then has just been a progression, almost like a disease that you are monitoring and the disease is spreading,” he says. “We are still a long way from a major bottom.”

He is watching for a sign of panic selling, but says it hasn’t gotten to that point yet. “Everything we are seeing looks like a typical bear market,” he says.”

Update: Barry has two interviews with Paul:
Q&A: Paul Desmond of Lowry’s Reports
Part II — Q&A: Paul Desmond of Lowry’s Reports

Technorati Tags Barry Ritholtz, bear market, decoupling, Employment, equity markets, Federal Reserve, Inflation, interest rates, monetary policy, Paul Desmond, stocks

Stock markets around the world plummeted Monday, prompted by pessimism about U.S. President George W. Bush’s plans to boost the U.S. economy.

Share prices in Asia, Europe and the Americas all plunged by significant amounts; Wall Street only avoided joining the tumble because U.S. markets were closed Monday for Martin Luther King Day.

Markets in Europe reacted with London’s FTSE 100 Index down 5.5 percent at 5,578.20; the CAC-40 in Paris down 6.8 percent to 4,744.15; and Frankfurt’s DAX dropping 7.2 percent to 6,790.19.

In Japan, the benchmark Nikkei 225 index closed on 13,325.954 points, a slide of 3.9 percent and its biggest dip in two years. Shanghai’s Composite index fell 5.1 percent.

Read the rest if you want to feel depressed.

This is probably a mix of the need for stimulus being a bad sign for the world economy, and a realization that the stimulus is also not going to be sufficient. I agree on both conclusions. My concerns over the economy have been expressed in no uncertain terms for some time, and I have given my reasons for doubting the efficacy of fiscal stimulus packages. Fiscal stimulus that relies on increasing spending is an especially false hope, except in rare circumstances. Tax packages that make the adjustments businesses and investors need to make less expensive can help, but to do so they would have to be substantial, and politically I doubt they will amount to much.

Interestingly, Paul Krugman has historically felt similarly. Unlike Paul, I doubt monetary policy can do much either.

An important thing to remember when we discuss the government stimulating the economy, is that the numbers involved are completely out of whack. Let us pretend that the government spending $145 billion actually subtracted not a whit from other people’s spending or investment. That it was all added spending in our economy that would not exist otherwise. This is frankly ridiculous, but let us for the sake of argument pretend it were true. Folks, when we are talking about a 13 trillion dollar economy, that seemingly large $145 billion seems awfully puny. Around 1%. That one percent is supposed to make a difference?

Of course, that is a completely unrealistic scenario, because in fact the government will borrow the money from somewhere, money that would largely have been spent or saved in another fashion anyway. Academic studies show large amounts of the stimulus will be used to pay down credit cards and other debt. Some will be saved. Whatever that is, it isn’t a stimulus.

Similarly, the Federal reserve, for all the sturm and drang in the papers over the massive liquidity injections, is similarly poorly positioned. They control approximately $30 to $40 billion in reserves. That is it. The amount of liquidity “injected” has been essentially nil. Almost all of it was just the federal reserve rolling over existing repurchase agreements with banks. They can attempt to lower interest rates, but that will have a long delayed impact. Politically the Fed and the government need to be seen doing something, but what they can do is vastly overrated.

I bring this up not to scold our politicians, or the Fed, but to emphasize that we as investors should not be fooled about such policies rescuing us if we are not appropriately positioned. Certainly we should be mindful of the last time investors were urged not to “fight the Fed.” Huge losses followed as many investors walked hand in hand with the Fed to interest rates as low as 1%. I chose to fight and I am glad I did.

The economy and markets may recover, but policy will not be the major determinant.

Other views:

Tyler Cowen points out that rebates don’t always accomplish what they are supposed to do.

Menzie Chen looks at business incentives.

James Hamilton makes his case against fiscal policy, and echoing my own thoughts thinks Bernanke was not giving the green light to it that many believe.

Paul Krugman has his own thoughts about what to do now.

Mark Thoma questions the efficacy of making tax cuts permanent.

Finally, via Abnormal Returns, Greg Mankiw asks great questions:

If some journalist out there talks to a member of the Federal Open Market Committee, here is the question I would ask:

If the economy now gets the fiscal stimulus being proposed (about 1 percent of GDP), does that mean that the Federal Reserve will cut interest rates less than it otherwise would?

My follow-up questions:

If the answer to the first question is No, then ask, Why the heck not? Monetary and fiscal policy are two tools available to increase the aggregate demand for goods and services. The goal here is to prop up demand sufficiently to maintain full employment without causing inflation. If the U.S. government is using fiscal policy more, it should use monetary policy less.

If the answer to the first question is Yes, then ask, How much higher will interest rates be kept as a result of the fiscal stimulus? And is it really better to have a fiscal stimulus and higher interest rates than a smaller deficit and lower interest rates?

More from Greg here, and here.

Update: Megan McCardle echoes my concerns:

As talk of stimulus plans grows, readers are asking for my thoughts. Which are: stimulus rarely works unless it is massive and very rapidly applied, and if it is massive and very rapid, it usually has much larger problems.

The difference between tax cuts and spending is irrelevant in theory. In practice, because so few people pay significant income tax, it has distributional effects. Since rich people seem to save more money than poor people, this blunts the effect of the stimulus. On the other hand, spending is generally much more distortionary than tax cuts, because the government picks what the money is spent on. One more reason not to like fiscal stimulus packages.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags federal government, Federal Reserve, fiscal stimulus, monetary policy

In retrospect, what should the fed have done differently?

Risk and Return is really about implications for investment policy, and thus identifying which factors have implications is key. Pumping for particular policy choices really isn’t our role. Still, in identifying what probably should have been done we can better recognize the impact of future events. Here is the quick, and therefore somewhat inelegant, response I gave him:

First, I do think interest rates were kept too low, too long. The goal was to inflate asset prices, specifically housing, to stimulate the economy. Of course, high asset prices mean lower returns later, or in this case, declines. That worked, but what do you do next? The loans encouraged by high, and rising, prices don’t make sense when that condition clears.

The fear at the time was a deflationary spiral (see Japan since the end of the ’80’s.) The problem I had with that fear, and it was legitimate, was that for all the issues surrounding the tech and stock bubble (the latter not being over) Japan’s crisis was a financial, and specifically related to a real estate bubble, collapse. In order to avoid the Japan disease, we have put those very same conditions in place. The tech and stock market bubble collapse (once again, that collapse is still in process, and will be for some time) was unlikely to lead to a Japan scenario. I don’t think this will either, but it certainly has much more of a chance, which makes the policy much harder to defend. Recessions come and go, huge financial crises are not to be played with, even if the worst case scenarios are unlikely.

Second, if you are going to inflate housing, and in essence create a strategy for raising prices that may not be sustainable long term, it certainly makes sense to curb speculative excesses and fraud through regulation. I am no fan of regulation, but irrational prices encourage irrational greed. Doing what you can to ensure loan quality in this kind of environment was a no brainer. At minimum fraud needed to be curtailed. That wouldn’t have avoided the crisis, but it would have made it less severe. The Fed created conditions, it then needs to work to ameliorate the risks to the broader economy those artificial conditions create. Low regulation environments make sense when the ultimate investors and home buyers pay for their greed or mistakes. The discipline of the markets. However, if you create a situation where that solution causes broader systemic issues due to your own policy, the market will not work it out, because politicians and economic actors can’t afford for that many people to suffer.

To elaborate, moral hazard is in play. Politicians will try and fix it, leading to a spiral of further regulation and short term fixes, reinflating of assets and a rescue which encourages the same excesses. Worse, these solutions are unlikely to make much difference in the short term. Their impact will be after the current problems are likely to have worked themselves out systemically already. If they haven’t, the problem is therefore likely beyond the policies ability to accomplish much and will sow the ground for future crises from declining asset prices, that is if there are any assets left to inflate. Housing doesn’t seem likely to easily recover merely due to lowering rates again, and long run, do we want their prices to stay artificially high?

To put it another way, wasn’t using interest rates and a hands off regulatory policy in tandem to inflate housing values among the root causes of what got us here in the first place? If so, then stretching the pain out too much may help avoid a true Japan scenario, though I don’t think that is likely, but it is very likely to set us up for problems for years to come. I don’t envy Bernanke, his choices are pretty unappetizing all the way around at this point.

As an aside, I think this is a good time to read about Ben, here is a thorough biographical article by Roger Lowenstein that has taken the financial blog world by storm. (via Crossing Wall Street)

Technorati Tags Anna Schwartz, assets, bubbles, Federal Reserve, Housing Market, Inflation, interest rates, Japan, loans, monetary policy, moral hazard, mortgages, regualtion

Fourth, in their desperation to “do something” politicians will often do something foolish. If a spending increase or tax cut isn’t worthwhile on its own merits then it’s highly unlikely to be worthwhile once we add in the benefits of “stimulus.” Thus, it’s one thing to argue for extending unemployment benefits as a matter of welfare it’s quite another to think that an increase in unemployment benefits will so increase spending as to reduce unemployment! (The implicit view of Larry Summers.)

I admit to being dubious of legislation and federal government action being useful for short term economic swings. Here are the other quite compelling reasons why:

First, the money for any new spending or tax cuts has got to come from somewhere, right? Thus there is usually substantial crowding out of any stimulus.

Second, by the time the new spending or tax cut gets through the political process the economy has moved on and the stimulus is no longer relevant except by accident.

Third, there just isn’t that much discretionary spending to play with and even a large increase in spending, say tens of billions, is too small to make much of a difference in a 13 trillion dollar economy.

My emphasis above. I am always amused at the power people ascribe to what seems to be a large action, but in the context of the US economy and financial system is actually pretty paltry. That goes for most actions undertaken by the Federal Reserve as well. Finally, even for those amongst us, especially economists, who find those arguments uncompelling, we should all remember this:

Economists may call for “temporary,” “conditional,” and “targeted” stimulus but they won’t be the ones designing the plan. Spending increases and tax cuts are policies with long term consequences that we need to think about carefully.

My own view relates to the first reason I quoted. Spending and tax decisions should make sense in and of themselves, not because of some quixotic attempt to influence the short term course of the economy.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags Alex Tabarrok, Economics, Federal Reserve, fiscal policy, Larry Summers, recession, spending, tax cuts, tax policy