Dr. Sherry Jarrell

Reader's Question: Is Bernanke the problem?

Reader Randy Tanner asks "Is Bernanke the problem?"  in response to a recent article by Vasko Kohlmayer titled Why Isn't Peter Schiff Head of the Fed? In that article, Kohlmayer makes the case that over the period 2002-2007, while Ben Bernanke was saying that the economy was strong, Peter Schiff was warning us about the coming housing bust, rising unemployment, and falling dollar.  

The short answer is no, Bernanke is not the problem, not in the way Kohlmayer implies, at least.  The Fed did not cause the financial crisis.  I personally do not like everything about the way the Fed responded to the crisis, in particular their purchase of toxic assets, but they did not cause the crisis.  

And, no, Schiff should not be running the Fed, even if I believed that successfully predicted falling housing prices, rising unemployment, and a weak dollar. Which I don't.  But again, not in the way you might think.

Being a good economist does not require one to predict the state of the economy during a certain window of time.  In fact, the very best forecasters know to not even try to predict economic activity beyond the next quarter.   

No, what good economists understand is cause and effect, and most of that occurs at the level of the firm, the consumer, or the transaction.  Extrapolating that to the level of the economy involves so many countervailing factors that "predicting" what will happen at the macroeconomic level is not really meaningful.  In other words, you can find someone out there at any point in time making predictions about macroeconomic outcomes who will end up being "right."  Eventually.  On some level.  And this does not help us to make better policy, to allow the economy to be as healthy and productive as possible.

Let me give you a specific example to help make my point.  And I agree at the outset that Randy's point is a difficult one to argue against, and that my point is fairly subtle.   What I believe was perfectly predictable was the impact of the political decisions that mandated easier and cheaper access to home ownership, and charged Fannie Mae and Freddie Mac with implementing those policies.  When the government inserts itself between suppliers and demanders, as it did with these policies, it distorts the price signal and gets either too much or too little of that economic activity.  

So what happened here?  Because of the mandates, banks made loans to individuals that they would not have otherwise, largely because Fannie Mae and Freddie Mac were standing in the ready to buy those mortgages from the banks and get them off the banks' books.  So the banks did not have to bear the risk of those homeowners defaulting on the loan.  Therefore, those mortgages were underpriced.  And if the interest rates had been higher, where they should have been, less creditworthy individuals (which include high income individuals overextending themselves with a second mortgage as well as low-income individuals overextending themselves with too much house) would have not have applied for the loan in the first place.  

If you lower the price of an activity, the demand for that activity rises.  So the mandates led to a situation where a larger-than-sustainable fraction of existing mortgages were high risk, were susceptible to foreclosure should the economy take a turn for the worse. THAT is what is predictable, not that the economy in fact took a turn for the worse.   

Left to their own devices and profit-incentives, banks are perfectly able to price mortgages and absorb the risk that a fraction of those mortgages will go belly up.  And the private economy is perfectly well equipped to pool those mortgages, combine the funds, and issue and fairly price various mortgage-backed securities.  

The problem centers on the fact that a politically motived player in the form of Fannie Mae and Freddie Mac used our tax dollars to pursue a social agenda instead of a dollar of profits.  Mr. Schiff seems to overlook this fact as a primary contributor to the financial crisis, and Mr. Bernanke, though I suspect is fully aware of the issues surrounding Fannie and Freddie, is not responsible for what Fannie Mae and Freddie Mac do, and must enact predictable monetary policy regardless of their actions.  

Again, I do have issues with the Fed's actions over the last few years, and I do worry about inflation and the loss of autonomy of the Fed to the brutish attitude of the Treasury, but those are separate issues in my mind from the supposed ability of Mr. Schiff to predict the housing crash and the financial crisis of the recent past.  

It is possible to flip ten heads in a row; unlikely, but possible.  And the 10th toss does not predict the 11th.  They are independent events.   Predicting the 11th toss based on the preceding 10 makes as much sense as predicting that housing prices will fall because they are now high.  Neither prediction is based on economics.   But when you use tax revenues to subsidize high-risk mortgages, economics correctly "predicts" that more foreclosures and financial distress will occur than would have otherwise. That's a prediction you can count on.

 

 

Fannie Mae and Freddie Mac: Scary

Fannie Mae and Freddie Mac are at the very core of the most recent financial crisis. Without them, the crisis would not have occurred.  Fannie Mae and Freddie Mac get between lenders and borrowers and distort the pricing of their transactions.   Fannie Mae and Freddie Mac have, as their mandate, social engineering, not arms-length business negotiations conducted for mutual benefit.  They have no business worming their way around our economy.  

Fannie Mae and Freddie Mac continue to operate because they make politicians better off, not business people or consumers. Someone is getting their pockets lined.  I believe that when the real operations of Fannie Mae and Freddie Mac see the light of day, that you will be stunned by the sheer magnitude of the fraud, corruption, and destruction of wealth.

You heard it here first.  

For fabulous reporting on all things housing, including Fannie and Freddie, I follow Nick Timiraos on twitter (http://twitter.com/nicktimiraos).

The "Wild" Swing in the Dow Jones: Some Perspective

Just to try to help put stock market swings into perspective, consider this:  

• the 347.8 point fall in the Dow Jones Industrial Average last week, from 10868.12 at the start of the trading day on Thursday, May 6, 2010 to 10520.32 at the close of trading, can be COMPLETELY explained by an increase in the perceived cost of capital from 12% to 12.23%.
• do the math.  Using the constant dividend growth model, a very simplified model of the market value of equity, or Market Value = Current Dividend/(cost of equity capital - dividend growth rate), and assuming a long-term average cost of U.S. equity capital of 12% and average growth rate of 5%, we find that the opening level of 10868.12 = 760.77/(.12 -.05), and the closing level of 10520.32= 760.77/(.1223 -.05).
• I think it is entirely possible that the chaos in Greece and surrounding nations, and the interconnections between worldwide supplies of liquidity and financial capital, that an increase in the perceived risk and uncertainty of the returns to equity from 12% per year to 12.23% per year makes perfect sense.
• The market's are working.  Market participants, from the individual investor using on-line trading at 2:00 in the morning from their living room to the most sophisticated computerized large-scale institutional trader, understands that a borrower's ability to pay back its investors depends on the real productivity and growth of private industry, whether the borrower is a company or a country.   

Are Derivatives to Blame?

Derivative securities are not inherently evil, though the media, and certain guest authors on this blog, would have you think otherwise. It seems that any type of investment that does not directly involve commodities is an easy target these days.

But derivatives are just another type of investment, those whose value is derived from some underlying security or asset or event.   Insurance is a type of derivative investment, as a matter of fact. If the bad event happens (a car accident, flood, or fire, for example), then a claim is made against the policy.  If not, the policy expires.   The value of the policy is derived from the insured asset or event.

If derivatives are bad, then so too is insurance.  If derivatives are bad, then so too are leases with the option to own.  If derivatives are bad, then so too is the equity in any type of company, small or large, private or public, including those that produce real products and commodities, for stock is nothing more than an option to buy the underlying assets of the company for the price of the face value of its debt.  If derivatives are bad, then so too are convertible securities and most every other type of financial innovation we’ve witnessed in the last 30 years, and for decades to come.

Should you Invest in U.S. bonds? Part 3

This is part 3 of a multipart series on the factors that drive U.S. and foreign bond prices and yields.

The yield on a bond is made up of several components. Some think of the return on a bond as the sum of the risk-free rate of interest (how impatient we are to get our money back, or how much we need to be compensated to delay consumption) and a risk premium (the additional return we require to compensate us for the risk of default, the risk the bond will be called, the risk of inflation reducing the purchase power of the repaid dollars, and many other sources of risk as outlined in the most recent article in this series).

Another useful way of thinking of the return on a bond is as the sum of the real rate of interest and the expected rate of inflation.  But what is the real rate of interest?  We never actually observe that rate, unless of course the inflation rate is zero and then the real rate is just the nominal rate set in the market.

It is useful, however, to think about what drives the ability of a company to generate a real rate of return to lenders, for this is essence of capitalism and risk-taking and creating economic value and growth.

Bond traders

A firm’s asset cash flows support the real returns to its lenders – all kinds of lenders (debt, equity, hybrid, and derivative security holders). A firm will want to borrow more, and is willing to pay a higher interest rate for those funds, the more profitable are the projects they want to undertake, or the greater the number of profitable projects. Profitability, in turn, is determined by the relationship between demand and supply:  how much does society value a good or service, and how many resources does the business use in producing the good or service.  As the marginal productivity or efficiency of a business goes up, it can afford to profitably fund more projects.  So the core driver of the real return on bonds is the strength of the underlying economic activity of the private economy.

Or, when viewed from the investor’s side, note that an investor will purchase a bond, or lend money to a company, if they expect to earn a return sufficient to compensate them, first, for delaying consumption and, second, for bearing the various sources of risk or uncertainty associated with the bond’s cash flows or return.

Bond’s in a weak or faltering economy will generate a lower return to lenders than bonds in a strong economy, absent inflation or any other material changes in the purchasing power of the currency.  Weak demand for goods and services means weak demand for financial capital which means low rates of return on financial capital.

The policies of the government can increase the borrowing costs of private industry.  Fiscal policy that increases taxes reduces the profitability of projects and undermines the ability of companies to pay coupons and repay principal.  Monetary policy that increases the money supply may lead to inflation, which also increases the cost of borrowing and reduces economic activity.

Lastly, and of the greatest concern of late, is the level of borrowing by the U.S. government.   Debt levels are at record highs, with no relief in sight. The AAA rating of U.S. debt is reportedly in jeopardy (Chicago Tribune editorial).  Both existing and new lenders worry about the ability of the U.S. government to repay. Yes, the can simply roll over existing debt by raising taxes or creating money to retire old debt and replace it with new, but the interest rate required by new lenders goes up as the ability of the private economy to sustain tax revenues falls and the risk of inflation rises (Moody's explains U.S. bond rating).

Both factors are in play now: an anemic economy with little hope that this administration will undertake policies that support business, and a ballooning money supply and weak dollar that undermine the purchasing power of the returns to lenders.  The returns to U.S. debt may still be healthy relative to those one can earn in other countries, but the spread is shrinking. The private economy remains fundamentally strong, thanks to the work ethic of the American people and the profit motive of the capitalistic system, but the policies of the U.S. government are straining those resources.

The Fed's Exit Strategy

Finally, we hear from the Federal Reserve about how they plan to unwind the billions of dollars of toxic assets they purchased over the last 18 months or so without creating further distortions in the U.S. and world financial markets (Fed lays out exit detail). This after the Fed barely acknowledged one of the most dramatic runups in the money supply in U.S. history. 

The announcement came in a speech by Brian P. Sack (pictured at left), the executive Vice President of the Markets Group at the Fed.  I am impressed by this guy. He seems to know what he's talking about and seems to understand how markets and fed policy interact.  

In earlier posts (http://www.sherryjarrell.com/2009/06/t.html) I wondered aloud how the Fed might accomplish this tricky task. It is a very delicate balance between reducing the money supply too quickly, which would spike short term rates, and too slowly, which would increase long-term rates due to worries about inflation (which occurs when money growth is higher than the economy's real growth, even if money growth is falling). 

The Fed, the article explains, apparently intends to let $200 billion of the estimated $1.25 trillion in new money supply simply "mature" by the end of 2011 without replacing it. This represents largely toxic assets. The Fed might let another $140 billion of Treasuries it purchased during normal open market operations mature at the end of 2011, but they aren't committing to that.  So that's about $340/$1,250 or about 35% of the historic increase in money supply that may be vaporized over the next 21 months. What about the rest?  It would be nice to know but....

The Fed is doing the right thing by explaining its policy intentions -- ANY of its policy intentions -- to the markets.  Markets want, need, and deserve information from our officials, something that has been sorely lacking of late. With information, lenders and borrowers can plan, they can optimize. Without information, guessing, withdrawing from the market, and fear rule the day. Not a good environment for economic recovery.

Lessons learned as a Government Intern

When lending is motivated by politics, losses are not far behind.

Years ago, in the summer of 1980, I worked as an intern in the Federal Home Loan Bank Board at the Department of Agriculture.  I was a senior in college majoring in business and had been accepted to the University of Chicago doctoral program.  I didn’t want to take the internship because I wanted to take more courses over the summer to help prepare me for the rigors of grad school, but my college advisor had openly worried that I was far too serious for a young person.  He strongly encouraged me to accept the internship and take a break from academics before I immersed myself in graduate school, and buried myself once again in all things economics!

The U.S. Department of Agriculture was a major lender

I agreed, but only after I had arranged to take 6 credits of independent study in D.C.  I chose to examine the Negative Income Tax program, one of the largest social experiments in U.S. history. More on that at another time. Today, I want to talk about what I learned from being an employee of the U.S. federal government.

The first thing I learned was that the “problem” with government work is not the people; well, not all the people.  There was one man who spent his entire day going back and forth to feed quarters to the parking meter rather than pay for public transportation or do his work.  He represented the worst in government employees.  Most all of the others I met were hard-working and honest people, trying to do a good job and make a difference.

President George H. W. Bush

No, I learned that the real problem was with the way the "work" is done in government. I worked for the Federal Home Loan Bank Board (FHLBB) that summer, which was one of the largest lenders in the world.  The FHLBB was responsible for small business, rural, agricultural, and economic development lending. My job was to review loan applications from community groups, fairs, farmers’ markets, and various municipal organizations to make sure that they were complete.  We did not analyze the applicants for creditworthiness.  Instead, if the application was correct and complete, and satisfied the application process, it was approved.  The FHLBB, which was publicly trashed by the first President Bush as being largely responsible for the savings and loan crisis, was abolished and replaced by the Office of Thrift Supervision (OTS) under the Department of the Treasury in 1989.  The OTS eventually expanded its oversight to companies that were not banks, including Washington Mutual, American International Group (AIG),  and IndyMac,  all implicated in the current U.S. financial crisis.

AIG

Little did I know back in 1980 that I was witnessing, from the inside, a government lending process that would lead to the most significant financial crisis since the Great Depression. Looking back, the outcome was perfectly predictable: when politics replaces profits as the motivation of the lender, it should be no surprise that losses result.

Why Did the Fed Raise the Interest Rate?

What does it mean when the Fed raises the interest rate? It helps to first understand how the Fed raises the rate, which may surprise some people.  The Fed does not "set" the interest rate as it might, for example, by declaration or edict or by fixing prices.  No, it targets a higher interest rate by contracting the money supply until that money supply intersects the market demand for money at a higher market-clearing rate of interest.
 

How does the Fed reduce the money supply? Typically by conducting open market operations, which is the purchase or sale of government securities by the Fed.  To raise the money supply, it purchases new government securities, paying for them by creating--out of thin air--reserves for the commercial banking system. To reduce the money supply, it sells securities which shrinks the amount of deposits in circulation in the economy. In other words, it reduces the liquidity or amount of credit in the system.  This is equivalent to reducing aggregate demand for the goods and services in the economy. (Yes, you heard right; an increase in the money supply increases the aggregate demand for goods and services by businesses and consumers.)

Raising interest rates is a contractionary policy decision.  It is designed to slow down the economy, reducing output and employment, and raising the equilibrium prices of goods and services in the economy.  Why would the Fed choose to contract an already anemic economy?  To head off inflation, which has its own set of insidious costs and distortions that significantly hurt the economy.

The Fed has always had to tread a very fine line between increasing the money supply enough in the short run to minimize the depth and length of a recession, but not increasing the money supply so much that it creates inflation in the longer run.   Excessive money growth is what causes inflation.  And over the last two years, the U.S. has witnessed a record-shattering increase in the money supply as policymakers struggled to deal with an unprecedented financial crisis.

I have been saying for months that this behemoth money supply would inevitably lead to significant inflation unless steps were taken to shrink it.  I believe the Fed has now begun to take those steps.