Reflating the Bubble?

September 25, 2009

by Mario Rizzo  

The Fed has decided to extend, at least through early next year, its program of purchasing mortgage-backed securities. The Wall Street Journal reports:  

“The Fed’s action signals its belief that the economy, while in recovery, remains fragile and that housing, which has seen some improvement in recent months, has only started to pull out of its slump.”  

What is the objective of their action? When will they know they have succeeded? Almost everyone admits that there was a housing bubble or, as I prefer to say, a misdirection of resources into the housing industry due to excessively low interest rates and other government programs designed to stimulate the housing sector.  

But now, again from the Wall Street Journal:

“Mainly because of heavy government intervention in the mortgage market, interest rates remain near their lowest levels in decades. Rates on 30-year fixed-rate conforming mortgages currently average 5.24%, down from a recent peak of 5.81% in June but up from the year’s low of 4.84% in late April, according to HSH Associates, in Pompton Plains, N.J.”

This intervention is good, even though the previous one caused the bubble, presumably because “the housing market has not fully recovered.”  What is full recovery? Business as usual? What is that?

The article continues:

“With so many empty houses sitting on the market, some builders say they still have no way to make a profit with new construction.”Why build new when people can go out and buy for less than it cost?” says Mark Connal, vice president of realty at Michael Crews Development, a developer and builder in Escondido, Calif.”

If the Fed defines full recovery as when it is profitable to build new homes, it has not grasped the fact that the housing sector is over-expanded. The point of losses or potential losses is to curtail the use of resources in this field. (If the Fed is claiming that the market is over-reacting in its curtailment of resources into housing, how do they know that? What is their standard?)

Thus, once again everything we know from microeconomics falls to the wayside in the Name of the Stimulus.

As if it were not enough that the Keynesians have fallen victim to this idea, the usually excellent Jeff Miron seems to think that the problem of reflating the bubble is mainly political, rather than economic. Of course, it is perfectly possible to interpret the Fed’s actions here as giving into the political pressure of the housing interests (real estate, construction unions, etc.), I do not think that is what he has in mind. Miron seems to think that the Fed can retrench at the first sign of inflation. But increases in the aggregate price level weren’t the problem in the first place. The housing bubble took place without “inflation.”

I just “love” macroeconomics.

15 Responses to “Reflating the Bubble?”


  1. 1) We had a bubble, that was bad.
    2) We are in a recession because that bubble has deflated, that is bad.
    3) We must blow the bubble back up again and call it recovery. This bubble will presumably be good.

  2. Mario Rizzo Says:

    Yes, that’s it in a nutshell. But I keep thinking there must be something more going on. These Fed people have “impressive credentials.”


  3. Doing the same thing over and over, and every time expecting a different result — isn’t that the definition of insanity?


  4. I agree with the above, but isn’t the Fed driven in part by the fear of debt-deflation?

  5. Mario Rizzo Says:

    On debt deflation: Perhaps, but resources need to leave the sector or, at least, continue to stay out. I would prefer that the Fed buy more long/medium term Treasury securities rather than prop up any targeted sector.

    When do resources get re-allocated? After the next “bubble”?


  6. I think it is both economics and politics. Anna Schwartz remarked that Ben Bernanke studied the Great Depression, but learned the wrong lesson. He is obsesssed with debt deflation, and I doubt he worries about microeconomics and resource allocation. On the political side, he is deferential to the Executive branch. The result is politicized monetary policy.

  7. John Papola Says:

    wait… you mean we can’t have a perpetual boom? We shouldn’t have zero interest rates forever?


  8. Please, no carping from the sidelines while the experts fix things.

    They’re getting the banking system back to normal, too…

  9. Mario Rizzo Says:

    Thanks, Charles. There is so much of importance in this interview that it is hard to digest. My feeling is that we ought to be happy the banks are not lending more money but, on the other hand, we ought to be nervous about the “theory” that says they should be.

  10. Bill Woolsey Says:

    If they are trully trying to expand housing demand and housing production to the levels of 2006, they are mad. However, I think they believe that there has been overshooting. Housing demand, prices, and production are all too low. They think that the housing credit market has been disrupted and they are trying to fix it. And so, they would like to see housing demand, prices, and production and somewhere between current levels and the “bubble” level of three years ago.

    There is a new Federal Reserve policy, and it involves identifying weak sectors of credit markets. It is hard to see how this cannot involve directing resources to particular sectors.

    Not all members of the FOMC support this approach. Lacker of the Richmond Fed spoke at the College of Charleston last spring and seemed critical of this approach.

    My own view is that monetary policy should aim at keeping nominal expenditure on a 3% growth path and the Fed should steer clear of trying to direct credit.

  11. John Papola Says:

    Could someone answer a question I have about Keynesianism, because I just don’t understand how this contradiction can exist and not put the whole darn thing to rest:

    So the interest rate is alleged to be a result of “liquidity preference” alone, right?

    How, then, can the central bank affect it by injecting reserves into the banking system?

    Why would real savings have no impact on interest rates, yet central bank expansion have an impact?

    These two things seems to be in conflict. Or am I not understanding what Keynes and his followers are asserting? Loanable funds as a market makes sense to me. This stuff doesn’t.

    thanks.

  12. Charles Stampul Says:

    Watch the bond market. The bond market has been driving everything. How do you know it’s the bond market when things move concurently? You got a clue a couple of times when bond auctions sold better than expected, so that’s where the news was made, and you saw stocks and commodities sell, and the dollar gain. Once the reflation catches, really catches, the bond market will collapse. This idea of the fed deflating (using the word in the correct way) we all know is a pipe dream. 70% of the U.S. economy is small business. If a universal health care bill goes through unemployment will double, now the fed is going to reign in stimulus?


  13. […] the comment section of Mario Rizzo's excellent blog post on the policy of reinflating the bubble, Jerry O'Driscoll explains what is going […]


  14. […] a recent post I criticized the extension of the Fed’s policy of buying mortgage-backed securities. Then I […]

  15. SM Pasha Says:

    Re John Papola’s question: almost everything Keynes said was in conflict. Most of his statements took the form of paradoxes. I’ve recently read a new book, Where Keynes Went Wrong, by Hunter Lewis, which lays this out very well. Keynes said that there was a problem of too much saving, that money printed by central banks was “genuine” savings also, and that the latter would cure the former by bringing interest rates down so that all the savings would be used. In practice, this just creates a bubble.


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