by Mario Rizzo
In an effort to prevent deflation, the Fed has now decided to do more quantitative easing, that is, to buy with newly created high-powered money various assets aside from short-term Treasury securities. Over the next six months it will buy up to $300 billion in long-term Treasury bonds.
It will also purchase additional mortgage-backed securities (MBS) in the amount of $750 billion as well as up to $100 billion in additional securities of Fannie and Freddie (to a total of $200 billion). These are the parts of the new policy that concern me most. They are bad ideas.
The ostensible goal of this is to bring down mortgage rates for a substantial period of time. If successful, this will have two effects: first, it will encourage refinancing of existing mortgages; second, it will reverse or retard the fall in housing prices as well as increase the flow of real capital and labor into the housing industry (at least relative to what it would otherwise be).
Is this a good thing? Certainly if you believe that housing prices have fallen too far and that too much capital and labor have exited the industry. In fact, however, there is no evidence of this. There is evidence of is the vast expansion of this sector relative to its long-run sustainable level during the recent boom-bubble. There is evidence that subsidizing the housing industry does not produce an efficient allocation of resources. There is evidence that as soon as “artificial” incentives to allocate resources to long-term (durable) purposes end, the sectors dependent on them collapse. So it is with some incongruity that the Fed believes its actions will bring about “a gradual resumption of sustainable economic growth” (Emphasis added).
It takes a vast hubris (in no short supply these days) to know – outside of the market – where the housing-market equilibrium is. (This is part of the “Macroeconomic Knowledge Problem” about which I have written.) Since it is true that markets can overshoot, it is plausible that they can undershoot equilibrium as well. The previous overshooting was caused by excessively low real interest rates. However, no one knew the top of the market or the date of the collapse ex ante. In the same way, even though there is doubtless much pessimism in the air, no one now knows where the new equilibrium is – least of all the commentators.
But even if we knew, two additional problems arise. First, monetary policy has lags of variable length. So it is uncertain when the Fed should begin selling MBS in order to for the housing market to settle at its putative equilibrium. Second, will the Fed be able to rid itself of the MBS at the appropriate time? It seems unlikely. In the next couple of years the Fed’s program will succeed in getting a vast interest group behind the new lower mortgage rates (this has happened in the past). So undoing the current stimulus is likely to take too long. A new sectoral overexpansion may well result.
If the Fed is right and we need stimulus in the form of new high powered money to prevent deflation (about which I have doubts), then it is much better for the Fed to restrict itself to buying long-term Treasuries. In this way the Fed does not build a specific, concentrated constituency based on a specific direction of resources. (Of course, this is not to say that there are not serious problems associated with the more general quantitative-easing policy as well.)
Tyler Cowen is right that the Fed’s policy “does not address most of the underlying problems in the real economy and as you know I see the ‘sectoral shift’ element of this downturn as very much underrated.” I would add that the Fed is not simply not addressing a problem but actively making the re-allocation of resources out of the housing sector less likely and thus retarding the general process of recovery.