The Fed Needs to Make a Policy Statement

More and more one hears the concern that the Fed has embarked on an expansionary policy that will result in high inflation once the economy returns to normal. John Taylor, a leading expert in this area, put the argument as follows, in recent Congressional testimony:

… the enormous increase in reserves is potentially inflationary. Many people ask me if it is inflationary, so I know it is on people’s minds. With the economy in a weak state and commodity and many other prices falling, inflation is not now a problem, but at some time the Federal Reserve will have to remove these reserves or we will have a large increase in inflation…Recall that increases in money growth affect inflation with a long lag. The question is whether the Fed will be able to reduce the reserves in time and whether people will expect the Fed to do so. If reserves get to the level [implicit in recent policy announcements] it will have to sell a huge amount of securities backed by consumer credit, mortgages, student loans, and auto loans. This will be difficult to do politically.

Employment decline compared to Depression

The March payroll employment data showed that the decline in employment from the peak in December 2007 is now larger in percentage terms than the decline in the worst recession since 1960, in 1981-82. The plot below shows, however, that the decline is small in comparison to the Depression. The government did not collect monthly employment data during the Depression, so we have fitted a smooth curve through the annual data. The peak before the Depression was in August 1929, according to the NBER.

Employment decline compared to Depression

The March payroll employment data showed that the decline in employment from the peak in December 2007 is now larger in percentage terms than the decline in the worst recession since 1960, in 1981-82. The plot below shows, however, that the decline is small in comparison to Depression. The government did not collect monthly employment data during the Depression, so we have fitted a smooth curve through the annual data. The peak before the Depression was in August 1929, according to the NBER.

The right way to create a good bank and a bad bank

Policymakers continue to struggle to figure out how to turn a troubled bank into a good bank and a bad bank. Under the good-bank/bad-bank policy, the good bank will operate free from concerns about troubled assets, because these assets will be held by the fully independent bad bank. Most discussions of the separation of a bank in this way presume that the government must inject a lot of new capital to create a well-capitalized good bank together with a still-solvent bad bank. The math seems simple–the troubled bank has almost no capital, so if the capital has to be split between the two banks, a well-capitalized bank will need new capital.

The Fed contracts

The Fed has indicated that it plans to pursue a policy of quantitative easing, that is, expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments. The Fed’s acquisition of large amounts of Fannie and Freddie’s debt was a notable success of that strategy, as it lowered their borrowing rates and thus lowered mortgage rates. But, as the graph below shows, the Fed has engaged in quantitative tightening over the past month, reducing its borrowing and reducing its holdings of higher-yielding investments. The line labed “Other assets” measures that type of investment. So far, no explanation for the Fed’s announcements of moving in an expansionary direction while actually contracting.

What to do about Fannie Mae and Freddie Mac?

Here are our recommendations. A discussion follows.

  1. The GSEs should be preserved, mainly because they are the most effective institutions for providing liquidity to the mortgage market.  Most mortgage investors, including depositories, prefer to hold liquid securities rather than illiquid whole loans. Wall Street securitization is not a substitute.
  2. Fannie and Freddie should be chartered as special-purpose banks, playing their historical roles of securitizing mortgages and holding some portfolio of loans.  Their debt should be federally insured or guaranteed, as are the deposits of banks, and as with banks, the equity of the institutions should be the first backup to bondholders as the capital (or equity) of banks is the first backup to deposits. Their insured or guaranteed debt should not be counted as part of federal debt, as the insured deposits of banks are not. They should be subject to capital standards and supervision of their activities, and subject to restrictions on their activities, like banks.  The capital standards, activity restrictions, and supervision need not be identical to those of banks.
  3. It is important to have two GSEs to assure competitive pricing of the guarantees on mortgages which go into MBS pools.  Guarantee fees are not posted prices, but negotiated in secret.  As a result, the pricing of guarantee fees is not collusive but  close to perfect (Bertrand) competition with two GSEs. In the trade-off of standardization and homogeneity to promote liquidity (which calls for fewer GSEs) vs. competition to assure competitive pricing (which calls for more), two gets an excellent result, likely the best result.
  4. There are three choices for F&F ownership:  1) owned by the government, like FHA and Ginnie Mae; 2) owned as a cooperative, by member institutions, as both once were, and 3) owned by the general public. Fannie and Freddie should be owned by public shareholders, as banks are.  We advocate ownership as public companies, but with explicit and priced federal backing, like banks.

Venture Capital in the Recession

While plant and equipment spending for the entire economy was down in the fourth quarter, it only fell by 4.4 percent from its level in the fourth quarter of 2007.  By contrast, venture capital investment was down by 31 percent.  In the fourth quarter of 2007, $8.1 billion was invested in 850 venture deals.  In the fourth quarter of 2008, $5.6 billion was invested in 790 deals. The number of deals is not abnormally small—over the last five years, the fourth quarter has seen 750 deals on average, but the total invested is down a lot from last year.