Fed Watch: Potentially Very Bad Policy

Tim Duy does his best to shoot down the trial balloon Treasury floated yesterday:

Potentially Very Bad Policy, by Tim Duy: Incoming data confirms that the economy slid into the heart of the recession in the fourth quarter. The ISM nonmanufacturing report posted a stunning decline in service sector activity. Like its manufacturing cousin, the underlying details were simply depressing, with the drop in the employment component setting the stage for a particularly week labor report later this week. ADP reported a sharp drop in private employment in November; this report has been underestimating declines in recent months, suggesting the possibility of a blowout number. Auto sales fell off a cliff in November, and I doubt December is looking much better. TheBeige Book provided grim anecdotal evidence consistent with the data.

Unfortunately, we will have more months of such data. With the economy already a year into recession, with the worst still ahead, not behind, policymakers will become increasingly desperate to do “something.” And that is exactly when some of the worst policy will evolve.

In the heat of the moment, we love crisis managers. But actions taken by crisis managers, who would argue that something just needs to be done, can yield very bad outcomes over the longer run. As much as I respect incoming administration members Timothy Geithner and Larry Summers, their efforts at crisis management during the Asian Financial Crisis left long lasting effects on the global financial system. During the Asian Financial Crisis, US Treasury officials thought it best to use the IMF as a club to beat struggling economies into submission. As a result, foreign policymakers around the world thought it best to accumulate massive reserves that fundamentally altered the path of capital formation in order to make the IMF irrelevant. Quietly watching while the US current account deficit expanded validated the global perception of the US as consumer of last resort and further aggravated global imbalances. And if you don’t believe those imbalances are at or near the heart of the current crisis, I urge you to read Brad Setser. Separately, the Federal Reserve in 1998 took on the job of financial market guardian with the LTCM unwind, thereby setting an expectation that the Fed would always prevent anything very bad from happening. But after taking on the responsibility, the Fed never followed through on oversight. Shouldn’t Citi’s off-balance sheet entities have raised more questions?

In all honesty, I hold Geithner and Summers less to blame for the aftermath of the Asian Financial Crisis than the Federal Reserve. Arguably, they never had the chance to offset the negative outcomes of their crisis management efforts; the stage was soon taken over by the Bush Administration, which set about eviscerating Treasury. And it is to Geithner’s credit that while at the helm of the New York Federal Reserve he tried to get ahead of the challenges in the CDS market. Overall leadership at the Federal Reserve, however, should have worked to correct the moral hazard they infused into the financial system.

This is not to deny the importance of crisis management, but to point out that when the crisis is over, you need to be able to correct for the excesses of your actions. With that in mind, crisis managers need to be wary of taking actions that they cannot revoke when necessary.

Which brings me to the trial balloon Treasury floated today; leaking plans to stem the decline in the housing market:

The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.

The key word here is “temporary,” implying a sunset clause. This is a program, however, that screams permanency. Once the federal government defines a right to low rate mortgages, they will find it very hard to reverse their position. (The Treasury may think they can make an arbitrage profit now, but just see what happens when the relative yields flip.) Why? Because at some point in the future, revoking the right will create classes of winners and losers, especially if it results in a steep rise in mortgage rates. And the losers will fight tooth and nail to prevent that rise; just imagine the army of lobbyists from home builders and realtors that will descent on Washington. (Separately, Calculated Risk questions whether or not the Treasury can meaningfully impact housing prices via the rate mechanism.) Moreover, it seems difficult to imagine that this program can be limited to those buying a home; why should those seeking to refinance be excluded? Wanting to stay in your own home is something the government should discourage?

The Fed has already stepped onto this dangerous ground by announcing plans to bring down mortgage rates by buying agency debt in large quantities. A reversal would threaten their political independence (which perhaps was lost long ago). To be sure, the Fed has always altered interest rates as a tool of monetary policy, and rate increases have always drawn the ire of politicians. But the Fed could always argue that the impact on home mortgages was simply an indirect consequence of their efforts to stem inflation in the economy as a whole. Now their actions are directly targeted at housing itself; they have announced they have the power to set mortgage rates. Politically, this is very different. At some point in the future, interest rates will need to rise, and I worry at that time the Fed will learn just how hard it is to taken away what Americans view as a God given right – government support for the housing market. Just think about trying to take away the home mortgage deduction.

Perhaps I worry too much. Perhaps it really will be temporary. Consider, however, who is behind this proposal:

The Treasury plan is similar to ideas previously floated by the National Association of Realtors and the lobby group for home builders…

I can only think of Adam Smith’s warning:

The proposal of any new law or regulation which comes from [businessmen], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

What is the alternative? Stop focusing on the housing market. Stick to policies that will be revocable when necessary. There are virtually unlimited opportunities for good policy in education, infrastructure, and health care, to name a few (Rebecca Wilder fears there may even be too many). The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers.

Final thought: Neither the Fed or Treasury would be in this position if the latter simply provided agency debt with the full backing of the US government. Then when mortgage rates needed to rise at some point in the future, neither agency would have to take responsibility for the resulting damage to the housing market. Simple versus complicated.


Originally published at the Economist’s View and reproduced here with the author’s permission.

10 Responses to "Fed Watch: Potentially Very Bad Policy"

  1. Jim Carroll   December 4, 2008 at 7:50 am

    “The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future.”How, exactly, can long term treasuries (say, the 10 year) be demonetized in the future? Doesn’t demonetizing imply the natural unwinding of the debt instrument? Isn’t this why the Fed normally operated on the short end of the yield curve – because the natural unwinding takes place with the expiration of the purchased debt?Therefore, I would think that this means demonetizing can only happen 10-years out, or the Fed must unwind their long term treasury position on the open market. The former implies “future” should be “far future” and the later implies the Fed may (and will probably) take a loss – which means the term “demonetize” ought to be the phrase “partially demonetize” since the loss would be irrecoverable.

  2. Joe Glynn   December 4, 2008 at 10:28 am

    So much for the Tragedy of the Commons, this looks like the Tragedy of Private Property. Systems theorists say if you try to maximise one variable in a complex system you will crash the system. The masters of the universe globalised and synchronised the housing/credit boom cycle for short term gains, and now ruination.It looked like policy couldn’t get any worse, but yes, appearances proved deceptive.Joe, Dublin

  3. MA   December 4, 2008 at 11:34 am

    @ Mark, I have to disagree.I believe the Quant ease is disaster waiting to happen, without escalating cash in the pockets of the public.The deflationary spiral has alreay started, and the public cash flow and willingness to spend has alreday decimated.Debt relief is the must. Inflating will only do well, without the existing debt burden and surplus cash.Have you tried to model this scenario? As an excel nut, I play with creating sim-economies, and only foresee debt destruction as the way out.Hyperinflation looms as a very real possibility the other way… and also poses the possibility of creating montary enemmies from differering countries financial plans.Miss America

  4. aerial view   December 4, 2008 at 2:57 pm

    What kills me about our fiscal policy makers, is that they knew the potential catatastrophe awaiting the economy well over a year ago when mortgage defaults and foreclosures rapidly increased and had a decent chance of averting the collapse of the system if they had acted aggressively to stop this: allow refinance at 3-4% and/or principal reduction to keep people in their homes! Now, of course, the solution has become much more complicated, costly and crippling not to just our country but to the rest of the world. It is no secret that the housing demise has had negative ripple effects on nearly every aspect of our economy and financial system. Additonal blame goes to the regulators and bond rating agencies who all looked the other way as unbelievable profits seemed to blind them all from morality, national interest or just plain common sense. If the people we elect cannot or will not do their job, they need to be held accountable for thier actions.

  5. Anonymous   December 4, 2008 at 3:31 pm

    There could be a interesting side effect of this approach.If the govt provides an attractive 4.5% 30yr-fixed mortgage only for new home purchases and not for refi’s, then mortgage holders who are otherwise ‘staying put’, ie not in danger of default etc – which btw is still 80+% of all homeowners out there, will have a HUGE incentive to sell the current house and buy a new one to get the benefit of a 4.5% 30yr fixed rate.After all, all this money injected into the system will in a 30yr time horizon likely cause huge inflation down the road. The attractiveness and predictability of a 4.5% 30yr fixed rate will be a powerful incentive to get out of ARMs or even other fixed rate mortgages, which are all surely higher than 4.5% today.This lowering the cost of the mortgage will of course be offset by an increase in the price of houses – which will increase the net worth of those that are not moving as well.Let the musical chairs begin!The key challenge in this all all other Fed/Treasury actions to date in this crisis still remains: we (kind of, sort of) know how to get in with these new-fangled weapons of innovative policy (or ‘crazy’ actions as Dr. Roubini puts it). We know a lot less how we are going to get out – ie. how do we reverse the actions taken now in the future.There is an Indian epic that has the story of a character named Abhimanyu who knew how to break into a spiral battle formation of an enemy in the battlefield, but did not know how to get out. This comes to mind.

    • Guest   December 4, 2008 at 7:22 pm

      While on the surface, this may appear to be helpful, it could have a disastrous side effect: more people trying to sell their homes, increasing inventory, decreasing prices and equity ultimately leading to more foreclosures: a vicious spiral down!

    • Anonymous   December 6, 2008 at 12:00 pm

      Interesting hypothetical result that would certainly benefit all the middlemen who trade in real estate. Seems like a mirroring of the shell game on Wall Street…make the money by increasing trading volume.

  6. Michael   December 4, 2008 at 7:11 pm

    @ Anonymous: Your thinking is very much like the people at the Fed and Treasury. Just tinker with this variable and Presto! you get exactly the specific, limited outcome you’re predicting. Very naive, and we have many many examples of “financial innovations” at the private and public level from the last 25 years that were based on this thinking and produced the “systemic catastrophe” we’re now spending all our time and money trying to stabilize. Your idea that arbitrarily lowering the interest rate on purchases but not refis will automatically result in an increase in sales by existing creditworthy homeowners for the specific purpose of shaving a point off their mortgage rate, resulting in “an increase in the price of houses” is a perfect example of artificially isolating one variable and (in this case clearly incorrectly) predicting a linear, contained outcome in an unstable, complex market system. May we all survive the many “This simple, great step will get everyone to act exactly thus” schemes that are beginning to drown us.

  7. Guest   December 4, 2008 at 7:30 pm

    There is another aspect of ‘ principal reduction’ bailout: If the bank “reduces” loan principal, therefore greatly reducing monthly payment, thus letting ” homeowner” stay in his/her “own” house, the forgiven part of principal has to be considered either as a “gift” to the person the “homeowner” purchased property from or as a ” capital yield” the former acquired. Then either 20% federal tax witholding will have to be executed ( just like for a plain interest) or capital gain tax will need to be assessed ( based on seller’s income bracket). Now, because we are talking quite substantial amounts of money – otherwise whole ” principal forgiveness” trick wouldn’t have been worthwhile – lump sum payment call from IRS would raise a havoc in “former sellers”group. Because they are obviously also ” homeowners” ( unless they stashed the $$ from sale and are now renting….), IRS judgements would generate epidemic of tax liens/levies and/or foreclosures. Messing with the guys who dilligently pay their mortgages ( ca 80% of all ‘ homeowners ‘) would create another monster…..

  8. Big Tee   December 4, 2008 at 11:11 pm

    The Fed needs to stop tinkering w/the system! They screwed up with low rates and no regulation to get us here! This country needs to stop “passing the buck”.Responsibility for ones actions needs to be retaught in academia; not new ways to escape responsibility. Time to take the losses! Those responsible homeowners shouldn’t have to bailout those who weren’t!By the way, the more we “pass the buck” the less it’s worth!