Inflation Is Not Measured Correctly

by Gunther Schnabl*

The European Central Bank (ECB) continues buying securities. By the end of 2017, the balance sheet is expected to have further grown by about 800 billion euros. This corresponds to a growth rate of 20 percent per year, while real growth of the euro area is expected to be only 1.5 percent. Despite this tremendous monetary expansion, euro area inflation remains below the two percent target. This raises the question of whether the quantity equation, which Mark Blaug called “the oldest surviving theory in economics,” is still valid.

Continue reading

Bo as Emblem of State Capitalism

by Chidem Kurdas

The fallen Chinese political chieftain Bo Xilai and his wife are starting to sound like a bizarre combination of Macbeth and his Lady, the US Department of Housing and Urban Development and Fannie Mae—yes, the government created and backed housing finance entity.

Under the leadership of the Mao-admiring “new left” Mr. Bo, the fast-growing city of Chongqing built extensive public housing. Apparently the local government  created investment vehicles to finance its various projects, issuing bonds with land as collateral. The WSJ reports that analysts regard this debt as increasingly riskyContinue reading

Fannie, Dodd-Frank and Barney Frank

by Chidem Kurdas

Barney Frank  won’t run for Congress after his present term expires.  This May there were news stories about his  ex-lover getting a high-paying job at mortgage finance giant Fannie Mae while he sat on the Congressional committee that oversaw the government-sponsored entity.  Continue reading

Fannie Freddie Lawsuit and Risk Arbitrage

by Chidem Kurdas

Last week the Federal Housing Finance Agency filed suits against 17 major banks and mortgage businesses for misleading Fannie Mae and Freddie Mac regarding the risks of mortgage securities sold to these government-sponsored enterprises.  Though it targets banks, the litigation shows the mode of operation of Fannie and Freddie.

This development is best understood against the background provided by a revealing new book,  Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, by V. Acharya, M. Richardson, S. van Nieuwerburgh and L. White, professors at New York University’s Stern School of Business. Here’s a quote taken from a decade-old American Enterprise Institute compilation of warnings regarding GSEs from free marketers and left-wingers alike. This is from a Fannie Mae executive:

“We’re not casual about managing our political risk.” 

By contrast, they were casual about managing their credit risk, Continue reading

Resource Allocation Distortions in the Great Recession: Empirical Evidence

by Mario Rizzo

The recent annual report of the Bank for International Settlements (BIS) has focused attention on the sectoral imbalances in the previous boom that resulted in the Great Recession. This is a refreshing change from the excessively aggregative analyses of the Keynesian-stimulus crowd.   Continue reading

Policy Makers and Irrational Exuberance

by Chidem Kurdas

Robert Shiller says the speculative bubble in real estate was driven by “a contagion of optimism” that pushed up prices and expectations in a feed-back loop. This epidemic apparently engulfed regulators as well.  “Government policy makers breathed in the same optimism, which no doubt encouraged them to be lax on regulatory restraint,” he writes in a NYT column.

This is a plausible explanation of the psychological mechanism that operates in any bubble. It eventually collapsed and led to the property slump that underpins the current economic malaise And Professor Shiller is right that public officials are not immune. But federal entities breathing in heady fumes is different from anybody else breathing in the same. Continue reading

Foreclosures

by Jerry O’Driscoll  

The New York Times reports that GMAC (now a subsidiary of Ally Financial) has admitted that it filed “dubious” financial documents.

The problem goes beyond GMAC. A Florida circuit judge is quoted as saying some of the documents filed by lenders are “incompetent,” some “just sloppy,” and he suggests “there could be a fraudulent element.”

In boom times, lenders cut many corners including loan documentation.  In the 1980s Texas banking crisis, regulators taking over failed banks often found it challenging to find loan documents.  Even if found, they could be defective.

Securitization has greatly complicated the problem.  Mortgages are sliced and diced into separate tranches of securities.  It can difficult to prove ownership of the mortgage. If the originator was sloppy in preparing the underlying loan documents, it can be an impossible task. Continue reading

Prices Must Be Free To Tell The Truth

by Mario Rizzo

According to an article in the September 6th issue of the New York Times, more and more “experts” are now saying that the government should not try to prop up the housing market but should let prices adjust to their correct levels as rapidly as possible.

Well, you read that here as early as November, 2008 and then again in March 2009. It is part of the continuing myopic harping on aggregate demand which ignores all of the relative price adjustments that a post-bubble economy must experience. The Keynesian habit of ignoring the causes of depressions and dealing only with the analytically-secondary phenomena of aggregate expenditure is or should be unacceptable among intelligent economists.

I repeat what I said in 2008: Let the housing market collapse — fast.

Fannie, Freddie and Mortgage Addiction

By Chidem Kurdas

In the first inning of what looks to be an intricate political game, the Obama administration and its financial industry allies suggested that the economy needs the federal government full force in the mortgage market.

The case was pithily made  by bond honcho Bill Gross,  who oversees more than $1 trillion of investments as head of giant bond shop PIMCO and was a speaker at the Treasury Department’s conference on the future of Fannie Mae and Freddie Mac.

“Having grown accustomed to a housing market aided and abetted by Uncle Sam, the habit cannot be broken by going cold turkey into the camp of private lending,” he wrote in a recap of his talk.

It’s an argument  that is at once practical and yet nightmarish. Heroin dealer has his customers hooked. They can’t do without him. Therefore they will have to make sure he stays in business and continues ministering to their needs. Continue reading

Econ. 101

by Jerry O’Driscoll

The AP reports today that sales of existing homes plunged 27 percent, despite the lowest mortgage interest rates in history.  How could this happen?

Part of the Obama stimulus package was a tax credit for homeowners who purchased homes within a stated time frame.  The credit has now expired.  Economic theory predicted the program would be a failure on its own terms and it was.

Housing is a durable good and the stimulus in effect was a one-time income transfer program. What does economics tell us that individuals do with transitory additions to income? They save most of it.  Because of the way this particular program was structured, the saved in the form of a durable good, that is, housing.   Continue reading

Summer Reading III

by Jerry O’Driscoll

According to Reinhart and Rogoff, “for the advanced economies during 1800-2008, the picture that emerges is one of serial banking crises.” In This Time is Different, the authors bring us up to the present by examining the history of banking crises. Banking crises are not only frequent , but often accompanied by other kind of crises.  These include exchange rate crises, domestic and foreign debt crises and inflation crises.  The current financial crisis is still unfolding, but we have already seen the clustering of crises.

They observe that banking crises are often preceded by surges in capital flows.  This finding may be controversial, but they detail it at length.

Banking crises are often associated with an asset bubble in housing. They compare the current housing and banking crises to others stretching back to one in Norway during 1898-1905. They devote considerable time to inflationary crises, which are quite common aftermaths both in earlier and more recent history (1500-1799 and 1800-2008).

That brings them to the subprime meltdown and what they term “the Second Great Contraction” (after the great Contraction, 1929-33).  It is an excellent and thorough presentation. They note historical studies calling into question the Fed’s policy of “benign neglect” toward the housing bubble under Greenspan and Bernanke.

The history of the aftermath of banking crises is sobering.  One salient fact: in the aftermath of 21 banking crises involving a housing boom and bust, real housing prices declined on average 35.5% over 6 years. By that record, we are but halfway through the housing bust. They find that “for banking crises, real housing prices are nearly at the top of the list of reliable indicators” (p. 279).  Once again, the Fed’s attitude toward the boom in housing prices is called into question by historical experience.

I recommend this book to all for serious summer reading.

Connecting Dots to Financial Crisis

By Chidem Kurdas

There are enough books about the events of 2008-2009 to fill a library. Nevertheless, there is no coherent framework that integrates the various factors in the dramatic boom-and-bust cycle that goes back to the late 1990s and may still be with us yet.  Bruce Yandle offers a welcome synthesis in the Independent Review, centered on trust-building devices and their dissolution. Continue reading

Understanding Efficient Markets

By Chidem Kurdas

Headline topics like derivatives are part of the larger issue of how markets function.  About this big question there’s been profound confusion in the past two years.  Peter Boettke’s article in the Winter 2010 issue of the Independent Review clarifies the muddle.

A particular mathematical interpretation of what an efficient market is has hogged the limelight.  Continue reading

Goldman Sachs Hate Week

by Chidem Kurdas

George Orwell’s classic novel, Nineteen Eighty-Four, describes a political ceremony called the Two Minute Hate, featuring Public Enemy Number One, a reprobate named Goldstein. People attend official rituals to work up a frenzy of hatred against Goldstein and love for their protector, Big Brother, or B-B.

To quote Orwell, at the climax of the Two Minute Hate, “the entire group of people broke into a deep, slow, rhythmical chant of “B-B! … B-B! …B-B!” – over and over again…” This daily rite is supplemented with elaborately prepared Hate Weeks.

In the past week there has been a similar fury in the media against Goldman Sachs, with herds of pundits all expressing their horror of the derivatives deal that is at the center of the Securities and Exchange Commission’s fraud case against the investment bank. This campaign starts with chants of “Social Benefit! Social Benefit! Social Benefit!” and climaxes with “Regulation! Regulation! Regulation!” Thus a mythical regulator stands in for B-B.

To pick one example out of many, George Soros writes that “Whether or not Goldman is guilty, the transaction in question clearly had no social benefit.” Mr. Soros is wise to hedge his bet about Goldman’s guilt—the SEC complaint contains holes the size of the real estate bubble. But was the mortgage-based collateralized debt obligation really devoid of social value? Continue reading

Just What We “Need”

by Mario Rizzo

Investors’ eagerness to invest in mortgage debt helped drive mortgage rates to all-time lows this week, Freddie Mac said.

The average rate on 30-year fixed-rate mortgages was 4.78%, the agency said Wednesday, matching a record low set in April. That was down from 4.83% from the previous week and 5.97% a year ago

I am amazed that aggregate-demand economists can look at the housing market and simply wonder how to bring it back to normalcy. Today the Wall Street Journal reports that investors are flocking to invest in mortgage-backed securities now that the Fed has been buying them. Freddie and Fannie are too big to fail, and so forth. The risk premium relative to Treasuries has fallen to the narrowest point this year.

From the investor’s perspective these are relatively safe problem-free investments. On the other hand, from the social perspective these investments delay the necessary adjustment of resources out of housing — remember: the over-expanded bubble sector?

Our aggregate-demanders (aka “Keynesians”) do not need to worry because during recessions the allocation of resources is not important. All that matters is propping up spending and restoring “confidence” in something called “the economy.”

UPDATE: A New York Times editorial argues that the housing stimulus is not working. What is their standard of “working”? It is hard to tell precisely. The complaints are that new housing construction has fallen, prices of houses are expected to fall still further and that more homeowners have negative equity. So presumably a policy that “worked” would have increased housing construction, propped up prices, and prevented the spread of negative equity. No readjustment in their play book! What is more disturbing, but predictable, is that the drumbeat for reconsidering the Fed’s plan to begin exiting the housing market has begun:

And the Federal Reserve, whose interventions have sustained the housing market over the past year, must show flexibility. The Fed has made it clear that it would prefer to begin withdrawing support for the market in the months ahead. But without other strong and successful fiscal measures in place, that could do more harm than good.

Stay tuned.

Pain in the Fannie

by Chidem Kurdas

As Fannie Mae goes for its next withdrawal from the $200 billion kitty the US Treasury graciously made available to this government-created and -sustained mortgage financer, it may be useful to look beyond the current housing slump and consider what it augers for the future.

Having made yet another loss, the government-sponsored enterprise needs more money. A report Fannie filed with the Securities and Exchange Commission attributes the $19 billion third-quarter loss to the housing slump and mortgage defaults.  “We do not expect to operate profitably in the foreseeable future,” says  the company.

I always thought it was a great triumph of government public relations to come up with the sweet-sounding Fannie Mae moniker for an entity officially called the Federal National Mortgage Association.  Now I understand what the nickname really means—a pain in the taxpayers’ backside for the foreseeable future.

The business has been adversely affected by helping delinquent or imminently-in-default borrowers to modify their mortgages so as to reduce their monthly payments. As the economy recovers, defaults will decline, and presumably this aid will no longer be needed. But it is not clear when – or even if – the subsidy program will end.

In fact, it may be extended.  Fannie “may recommend supplementing the program with other initiatives that would allow us, pursuant to our mission, to assist more homeowners.” Continue reading

Reflating the Bubble, Part II

by Mario Rizzo

In a recent post I criticized the extension of the Fed’s policy of buying mortgage-backed securities. Then I was told by a quite-knowledgeable economist that I may have misread the report in the Wall Street Journal. The first sentence states:

The Federal Reserve, in a move aimed at keeping interest rates low for home buyers through early next year, decided to extend and gradually phase out its purchase of mortgage-backed securities. (Emphasis added)

So while it is true that the Fed is extending the program, it also plans to phase it out. I replied (in private email) that I preferred to pay attention to what the Fed is actually doing rather than to what it is promising to do. Continue reading

Reflating the Bubble?

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? Continue reading

Auction Markets and Optimally Sticky Prices

by Joseph T. Salerno

Keynesian macroeconomists, old and new, have long criticized their classical and contemporary opponents for ignoring reality and treating the market economy as a giant auction in which prices are “perfectly flexible,” responding instantly to changes in supply and demand.  This charge is wrong on two counts.  First, all markets for outputs and inputs function precisely like auctions; and, second, auctions are not characterized by perfectly flexible prices but by an optimal degree of stickiness in prices that is determined by the market itself.

In this post I will deal with second point, because it has been generally neglected in responding to the Keynesians.  To illustrate this point I will use the example of a one day on-site auction of 49 unsold condominiums at a 73-unit complex that recently took place in Auburn, Alabama and which I also happened to attend. Continue reading

Prices and Information

by Jerry O’Driscoll  

In the recent discussion of Say’s Law, the issue of “sticky” prices came up. The term is the source of much confusion. The opposite of “sticky” prices is not “flexible” prices, but infinitely flexible prices. No matter how flexible a price, short of infinite flexibility, there will be quantity responses. Quantity responses are an inherent part of market economies, do not signal market imperfections, and do not typically trigger income-constrained processes.  

Price setting incurs information costs. How does a producer or  retailer know when to change his prices? Where does that information  come from?   Continue reading

“Prices Must Be Free To Tell The Truth”

by Mario Rizzo

I am not sure who first said this but I believe it was the economist Benjamin Anderson (although Arthur Marget has been credited). In any event, Henry Hazlitt promoted the statement.

I think the very interesting opinion piece by our regular guest-blogger, Jerry O’Driscoll, in today’s Wall Street Journal is in the tradition exemplified by this post’s title. But there is something more. The article shows that falling prices (both absolutely and relatively) in particular markets are not a bad thing for the recovery process. Naive Keynesians get upset anytime an important price goes down. Oy gevalt! What will happen to aggregate demand? There will be a cumulative decline, and so forth.

Recovery doesn’t mean maintaining or going back to unsustainably high prices. (I offered my two cents in the Freeman.) It must involve readjustment of relative prices as a result of the credit-boom and bubble generated distortion of relative prices. Jerry’s article reminds of us all of some basic truths.