Quick Note on Bernanke

I’m headed off to a conference, but I just wanted to voice my disgust with Ben Bernanke quickly. Here is what I gathered from his speech in Jackson Hole:

1. The Fed has the tools to offset shocks to money demand, but only sees fit to use them in the event that the country is facing actual deflation.

2. The Fed is highly committed to memory-less inflation targeting, and is happy living with inflation below 2%.

3. The Fed will not offset contractionary fiscal policy, handing proponents of active demand management victory on a silver platter, though they don’t deserve it.

We will have to wait until the next Fed meeting to see Bernanke’s “real” intentions on monetary policy. Will he steer the committee into a more aggressive stance? The stock market is very slightly up on the speech, so maybe WAll Street knows something that I don’t…but I just can’t see how an aggressive policy move is in the cards.

The Fed Rejects Level Targeting

Remarks from Ben Bernanke indicate that the Fed is shooting itself in the foot:

“I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy,” [Bernanke] said.

In fact, the Fed should engage in level targeting, as I have been pushing in the last few posts. It should commit to a higher target for nominal expenditure in order to return to the previous trajectory from the Great Moderation. That requires a higher level of NGDP growth than is “normal” in order to catch up. One way to do this under the current monetary regime is to create higher inflation expectations. Do they need to be much higher? I don’t think so, but it’s not entirely unreasonable to disagree.

So we know that most members of the FOMC view 2% as the preferred inflation target. We now also know that the Fed is holding true to that target, come hell or high water. 2% is better than 1%, but a temporarily higher target would produce a much more robust recovery. Arguably, the Fed is in the business of providing stable NGDP growth consistent with high employment and low inflation. It allowed NGDP to plummet and now they should be trying to make up that lost ground as quickly as possible. This statement is clearly against that goal.

We’re in for a rocky road if our monetary authority sees it fit to tie its hands.

Money is NOT Easy, and Never Was!

Update: I probably should have put “during the recession” in the title. Unfortunately it’s gone to press.

Chevelle, at Models and Agents, explains why the previous round of “quantitative easing” performed by the Fed did not have a [sufficient] expansionary effect:

By that metric, the Fed’s past LSAPs have probably fallen short. Clearly, measuring the counterfactual is impossible, but there are reasons to believe that the impact on aggregate demand was small. Why? First, because the reduction in mortgage rates boosted refinancings only by people who could refinance—i.e. people with jobs and some positive equity in their home. Not exactly the most cash-strapped ones who would have spent the extra cash.

Second, the portfolio-balance effect of the LSAPs on the prices of assets like corporate bonds or equities is at best weak, if not counterproductive. The reason (which I explained in detail here) has to do with the fact that US Treasuries and MBS are not “similar in nature” to corporate debt and equities. Unlike the latter, Treasuries/MBS have more of a “safe haven” nature—so that removing them from investors’ portfolios create demand for more “safe” assets, rather than boosting the prices of equities, high yield bonds, etc.

Luckily, one Benjamin S. Bernanke explained how to perform private asset purchases that would, in fact, have an expansionary effect:

If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

If you see that guy around, tell him to talk to the Federal Reserve. I remember hearing a podcast with Scott Sumner a while back where he floated the idea of the Fed buying bonds off of the public (i.e. You and I), and paying for them with cash. Lets get to it!

Relearning the lessons of the Great Depression: Housing markets edition

There was an article last week in the New York Times about economists calling for the government to simply allow house prices fall and reach their bottom, an idea which is gathering more and more support. I think this is a bad idea because the real costs falling home prices are obvious, likely, and severe, while the benefits are vague and speculative.

For starters, as the following chart from Calculated Risk shows, in Q1 2010 there were millions of homeowners who are in a negative equity position. If prices fall another 5%, each of these bars will shift to the left one position. If prices drop 10%, they will shift two.

Lets make the conservative assumption that there are as many people right now in the 0% to +5%, +5% to + 10%, and +10% to +15% bins as there are in the -5% to 0% bin. This means we’ll get another 1.8 million borrowers underwater for each 5% fall in prices. If they fall 15%, that means 5.4 million more.

As you can see though, the numbers of homeowners in each category get larger as they approach zero, going from 1.1, to 1.3, to 1.5, to 1.8 million in the last 4 bins. So it’s likely we’ll actually get upwards of 6 million more homeowners underwater.

In addition, a fall of 15% would push around 1.9 million more homeowners into 50% or more of negative equity, driving this number up to around 6 million. These large increases in total negative equity will drive a wave of foreclosures. The best evidence indicates that foreclosures, in turn, will decrease nearby home values by 1% to 2%, which could exacerbate the foreclosure blights many neighborhoods are already facing.

Why are these foreclosures a problem? Most economically literate readers will be familiar with Bernanke’s famous paper on non-monetary causes of the Great Depression, where he makes the case that an increase in the cost of credit intermediation worsened the Great Depression. In contrast to the argument for how bad things can get when banks fail, few seem to focus on aspect of Bernanke’s paper that focused on defaults and bankruptcies as a mechanism for deepening the depression. In fact Bernanke even discusses the drying up of credit for homeowners as one of the important channels through which the credit system was failing:

Home mortgage lending was another important area of credit activity. In this sphere, private lenders were even more cautious after 1933 than in business lending. They had a reason for conservativism; while business failures fell quite a bit during the recovery, real estate defaults and foreclosures continued high through 1935….

To the extent that the home mortgage market did function in the years immediately following 1933, it was largely due to the direct involvement of the federal government.

Removing the existing government supports for the housing market now will allow this important channel of credit to dry up. As Bernanke recognized, this could worsen and lengthen our recession.

Another problem is that when a buyer defaults they lose a real asset: their credit. As near as I can tell from Googling around, credit scoring agencies have not adjusted their models to decrease the damage that a foreclosures does to your credit score. This seems puzzling to me as economists seem to agree that the huge fall in house prices was largely unpredictable when many of these mortgages were made. Defaulting on a mortgage in 2010, one would think, is not nearly as much of an indicator of lacking creditworthiness as defaulting on a mortgage in, say, 2005.

In any case, when defaults happen a real asset which gives borrowers access to credit goes away and the cumulative creditworthiness of U.S. households falls. In a recession, when borrowing and investing are important means of driving economic activity, this is not a good thing.

I believe the reason that falling home prices are getting support is what Karl calls The Pain Bias. Somehow, falling prices feel like tough love, and it feels like borrowers will be more confident. And it may be the case that another 15% fall in prices will convince people that prices are at a bottom. But along the way to that bottom real economic damage will be done. If that damage is great enough, and hurts economic growth, those rock bottom prices may fall even further.