Monthly Archives: December 2012

What Does the Monetary Exit Path Look Like?

Posted on by

I wish to provoke a discussion in the blogosphere of what economists expect the exit path to look like. John Taylor recently wrote,

assuming the central tendency forecast of the FOMC, the announced buying spree will bring reserve balances to about $4 trillion in mid-2005mid-2015. The risk is two-sided. If the Fed does not draw down reserves fast enough during a future exit, then it will cause inflation. If it draws them down too fast, then it will cause another recession.

Taylor used to be rather highly regarded in the field of monetary economics, but he has fallen out of favor with KruLong, Scott Sumner, and others. Still, I think his concerns deserve a response.

I am not sure what Richard Fisher means by“Hotel California” monetary policy, but it sounds as though he, too, is worried about the exit path.

My response would be that I am not concerned about the inflation-or-recession dilemma. I do not see a knife-edge there. I can picture a gradual transition from high unemployment to moderate unemployment, with inflation rising but staying under control–say, 3 percent. I am not predicting that this will happen, but I can picture it.

But suppose we do reach a point where the Fed has hit its unemployment target and inflation is around 3 percent? And at that point the Fed is sitting on a balance sheet of close to $4 trillion (even if this $4 trillion estimate is off by a trillion or two, we are still talking about real money, if I may allude to Senator Dirksen). And assume that fiscal policy still consists of running huge deficits as far as the eye can see.

When the Fed starts selling securities to limit the rise in inflation, what happens in the government bond market? There I do see the possibility for a knife-edge, or two very different equilibria. There is a good equilibrium in which bond investors remain confident, and rates remain low. There is a bad equilibrium in which bond investors get nervous, and rates jump. A transition to the bad equilibrium is always a possibility–that is what makes sovereign debt crises arise suddenly with no near-term warning. My worry is that a transition by the Fed from buyer to seller in the bond market could be the trigger that sends the markets to the bad equilibrium.

What is the scenario for avoiding the bad equilibrium? Some possibilities

1. No matter how many bonds the Fed sells, markets can absorb it, no problem. Why would this be?

a. Liquidity trap. For those of you who believe in liquidity traps (not my religion, but to each his own), do you think they still obtain when inflation is 3 percent?

or

b. Rational expectations. Not my religion, either. But you might say that by the time the Fed starts to sell, markets will have already forecast and discounted the Fed’s actions.

2. The Fed can achieve its inflation-stabilization goals by merely selling off teeny-tiny amounts of its bond holdings each year, for, say, twenty or thirty years.

I assume that many (most?) advocates/defenders of the Fed’s strategy believe something like (2). But what is the basis for that belief? We’ve never done this before.

By the way, I will not blame the Fed if this ends badly. To me, the original sin is the non-stop, out-of-control deficit spending. It is really hard to avoid having that end badly, no matter what the Fed does.

Happy holidays.

Defeatism and Appeasement

Posted on by

Peter Berkowitz writes,

In these circumstances, conservatives must redouble their efforts to reform sloppy and incompetent government and resist government’s inherent expansionist tendencies and progressivism’s reflexive leveling proclivities. But to undertake to dismantle or even substantially roll back the welfare and regulatory state reflects a distinctly unconservative refusal to ground political goals in political realities.

Former Bush officials Bradley Belt and Philip Swagel join Jared Bernstein and William Gale in proposing a compromise on the “fiscal cliff.”

Our proposals are explicitly temporary. We propose a one- year, $200 billion tax refund to support household spending, with rebate checks of about $1,200 for a couple and an additional $600 a child sent out in the first half of 2013. As with a similar measure enacted with bipartisan support in 2008, the tax rebates would phase out for higher-income households, focusing the cash on low- and middle-income households.

We would add $50 billion for spending to rebuild roads, repair and modernize public schools, and fund scientific research. We see a need for a sustained increase in infrastructure spending, even in the face of the long-term fiscal adjustment. This amount is meant as a start, and in recognition that only so many high-quality projects can be initiated in 2013.

Thanks to Reihan Salam for the pointer.

While Berkowitz, Belt, and Swagel are all reasonable individuals, I reject their approach. I think that defeatism and appeasement are the wrong response to the election and to the Orwellian media environment, in which the definition of fiscal responsibility has been reversed from what I know it to mean.

I may be committed to being charitable to those with whom I disagree, but my disagreement with progressives is profound. I will articulate my views whether or not other people come around to them. I see nothing to be gained by pandering in order to win public support.

An Equal and Opposite Fact

Posted on by

Sumit Agarwal, Efraim Benmelech, Nittai Bergman, and Amit Seru write,

We use exogenous variation in banks’ incentives to conform to the standards of the Community Reinvestment Act (CRA) around regulatory exam dates to trace out the effect of the CRA on lending activity. Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tract month that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks. The effects are strongest during the time period when the market for private securitization was booming.

Robert B. Avery and Kenneth P. Brevoort wrote,

We rely on two empirical approaches. In the first approach, which focuses on the CRA, we conjecture that historical legacies create significant variations in the type of lenders that serve otherwise comparable neighborhoods. Because not all lenders are subject to the CRA, this creates a quasi-natural experiment of the CRA’s effect. We test this conjecture by examining whether neighborhoods that have historically been served by CRA-covered institutions experienced worse outcomes. The second approach takes advantage of the fact that both the CRA and GSE goals rely on clearly defined geographic areas to determine which loans are favored by the regulations. Using a regression discontinuity approach, our tests compare the marginal areas just above and below the thresholds that define eligibility, where any effect of the CRA or GSE goals should be clearest.

We find little evidence that either the CRA or the GSE goals played a significant role in the subprime crisis. Our lender tests indicate that areas disproportionately served by lenders covered by the CRA experienced lower delinquency rates and less risky lending. Similarly, the threshold tests show no evidence that either program had a significantly negative effect on outcomes.

It was from David Weinberger that I first heard the suggestion that facts do not settle disputes, because for every fact there is an equal and opposite fact.

Note that the Agarwal paper does not refer to the prior Avery paper, so that there is no discussion of the opposite conclusions arrived at by the two approaches.

Market Failure in Government

Posted on by

Bryan Caplan writes,

Coming soon: The Tiebout model is wrong in fact, but how can it be wrong in theory?

The Tiebout model is a model of government competition based on exit rather than voice. If you do not like your local government services, then you leave. That forces governments to get better.

I think that the market for government services fails, for a number of reasons. First, exit is difficult. I would gladly trade my Maryland government for the government in Texas or for that of a Swiss canton. But my friends are in Maryland.

Second, there is a lot of bundling. Government is like cable TV. You have to buy the whole package, not just the channels you want. In the case of cable TV, the justification for this is high fixed cost. Once you have the cable hooked up, the marginal cost of a particular channel is low, so it makes some sense to charge a bundled price.

In the case of local government, I think that the bundling is more pernicious. It is not the case that bundling K-12 schools with snow removal serves to spread a high fixed cost that covers both.

In the third part of the widely-unread Unchecked and Unbalanced, I talk about steps that could be taken to make government more competitive by making it easier to exercise the exit option.

The 30-year Fixed-rate Mortgage

Posted on by

From my essay on mortgage interest-rate risk:

Interest-rate risk migrates toward those financial institutions that enjoy the highest level of perceived government protection with the least effective form of regulation. The perceived government protection enables them to serve as reliable counterparties to households and firms seeking risk protection. The relatively less stringent regulation leads the risk-bearing institutions to reap gains when interest rates are relatively stable, without having to hold sufficient capital to survive a major shock.

…Suppose that regulators actually succeed in locating all of the bearers of interest-rate risk and holding them to strict capital standards. I believe that the consequence of this will be that the interest rate on 30-year fixed-rate mortgages will rise significantly relative to mortgage instruments where rates are fixed for a shorter period.

The Three Axes and the Middle East

Posted on by

I have been suggesting that a model of three axes helps to organize ideological differences. Conservatives emphasize the civilization-barbarism axis. Progressives emphasize the oppressor-oppressed axis. And libertarians emphasize the coercion-freedom axis.

Consider the relationship between Israel and the Palestinian Arabs. To conservatives, the Arab tactics, such as suicide bombing and firing rockets from civilian homes into civilian areas, are barbaric. Conservatives tend to be pro-Israel.

Progressives are inclined to view the Palestinians as the oppressed in the oppressor-oppressed narrative. As Secretary of State Clinton put it recently,

the Israelis need to do to demonstrate that they do understand the pain of an oppressed people in their minds.

George Gilder, in The Israel Test, excoriates progressives for this view. He argues that Palestinian Arabs are helped by Jewish success, not oppressed by it. He points out that economic gains for Palestinian Arabs were greatest during the 30 years between the 6-day war and the launching of the intifada. Gilder’s book is a celebration of the positive-sum nature of markets and a condemnation of the oppressor-oppressed narrative. Israel is almost beside the point–it performs for Gilder the same function that risque scenes did for Ayn Rand. Rand lured teenagers into reading pro-capitalist lectures, and Gilder wants to lure Zionistic liberal Jews down the same path.

Although he is pro-market, Gilder does not speak to libertarians, and he certainly does not speak for them. Libertarians generally do not concern themselves with the Middle East, other than to suggest that the United States stay out of it and stop providing foreign aid. However, one strand of libertarian thinking assigns substantial blame to Israel for being ethnocentric and coercive. My guess is that this comes from Murray Rothbard, and it is part of his “revisionist” analysis that argued that the Cold War was the fault of the West, with Soviet Policy defensive. I do not find the revisionist view persuasive. I think that what we now know of the history of Eastern Europe suggests that the Soviets were very pro-active in their “defensive” maneuvers. In an alternative history, suppose that the United States makes no effort to create NATO or express an interest in Europe. According to Rothbardian vision, as a result Western Europe would have been left alone and Eastern Europe would have been freed. I think that the former is doubtful and the latter is certainly false.

Similarly, I doubt the Rothbardian vision that Palestine without a Jewish state would become a secular bastion of individual rights. There are indeed many Arabs who have that as an ideal. But they do not seem to hold sway anywhere. The Middle East strikes me as mired in ethnocentrism, coercion, and I daresay barbarism. I understand that Zionism is not a libertarian ideology. But that does not make me particularly excited by anti-Zionism.

Underwriting Waivers

Posted on by

Garett Jones read an obscure audit report from the Federal Housing Finance Agency, the regulator of Freddie Mac and Fannie Mae. The report says,

During the housing boom, Fannie Mae issued a substantial number of variances – reaching over 11,000 in 2005. Many of these variances increased credit risk and effectively relaxed underwriting standards. For example, from 2005 to 2008, Fannie Mae granted variances that included many higher-risk features, such as loans made with unverified income or assets, or little or no down payment…loans Fannie Mae purchased during this period were characterized, on average, by higher LTV ratios and lower borrower credit scores than those the Enterprise acquired from 2009 to September 2011.

As I read it, each variance could result in many loans. That is, a variance (at Freddie Mac we called them waivers) is an agreement with a lender to accept a certain number or fraction of loans (sometimes waivers allow for an unlimited number of loans, but that is rare) with characteristics that violate a provision in the standard guidelines. It could be something trivial (like using a bank statement record of automated pay deposits instead of an actual pay stub as documentation for income) or something major, like allowing 110 percent LTV (loan-to-value) on a cash-out refinance (this probably did not happen). So I am not sure that the number of variances is always going to be a reliable indicator of credit quality. But in this case, it probably does tell us something.

The Three Axes and the 1960s

Posted on by

Paul Rahe writes,

Liberty requires a responsible citizenry, and the sexual revolution (very much like the drug culture, which was and is its Doppelgänger) promotes irresponsibility of every kind. It promotes dependence, and it fosters an ethos in which those who exercise the virtues fostered by the market are punished for doing so and in which those who live for present pleasure are rewarded.

This is the way conservatives tend to view the cultural legacy of the 1960s. Along the civilization-barbarism axis, they view it as a slide from civilization toward barbarism.

Of course, progressives see it entirely differently. Along the oppressor-oppressed axis, they view the cultural changes as favorable, because women were liberated (a conservative would put scare quotes around “liberated”).

Along the libertarian’s coercion-freedom axis, the picture is mixed. On net, did the cultural changes lead to more or less government coercion? It is hard to say. For example, in the area of Civil Rights, I would argue that getting rid of Jim Crow laws reduced government coercion. (Note that in the early 1960s, prominent libertarians tended to take the states’ rights position, which strikes me as misguided.) However, there is a sense in which today government is overly intrusive on matters of race. (You may be happy with that if your concern is with the oppressor-oppressed axis, and you believe that government is helping the oppressed.) I would prefer that government model treating people as individuals by refusing to classify people by race (You may be very unhappy with my suggestion if you think that the oppressor-oppressed model is significant).

What to think of the unwed mother? To a conservative, she represents a slide down the slope away from civilization. To a progressive, she represents the oppressed “single mom.” To a libertarian, she represents someone who has made a choice. I think that conservatives and libertarians would agree that the state should not be the substitute father. However, it is quite a stretch to suggest that undoing the cultural revolution ought to be on the libertarian agenda.