Market-oriented Republicans see the housing crisis and say, “The market is working, and will, if only we let it.” Democrats see the temporary pain of the slowdown and say that we need a stimulus. Missing from both accounts is any talk of monteary policy; today, monetary policy is out of the hands of the domestic market and in the hands of the Federal Reserve. It is a government agency with a twist: with worldwide currency markets, the Fed must act like other market players at least in regard to international markets or our currency will be rejected or devalued (as it has been in recent months). More important, like players in any other competitive market, the Fed can make mistakes, particularly as it balances its contradictory mandates of stopping inflation and keeping full employment.
Republicans should take notice that markets have always been vulnerable to force and fraud and do not work well when those threats are undetected and unpunished. This is why we have laws. This is why in the “internal market” of a corporation people are fired or rewarded for making money for the company. Mortgage markets are vulnerable to fraud where obligations travel up a chain from buyer, to broker, to bank, and finally to some mortgage backed security holder. The broker gets paid up front even though the real risk holder bears the cost of default down the line. This is cause for external regulatory reform and also internal business structure reform. For example, wouldn’t banks and brokers be more careful if they had to return some of their commission (or otherwise be penalized) if whatever they sold had to be refunded if it defaulted within, say, five years? Alternately, they could be paid partially by a stake in the mortgage backed securities holding their notes. Bundles of mortgages could be valued based on a particular bank, broker, zip code, or some other combination of common, information-bearing factors. Brokers, banks, and anyone who gathers information from lendees ideally should have “skin in the game.”
These mortgage backed security holders should not be bailed out, of course, as this conflict of interest between lender and note holder should have been apparent to anyone purchasing these instruments. Spreading risk may still be valuable, however, and would be more so in a proper environment of incnetives, including targeted regulation. (We should also consider how much of this craziness was a function of the rates themselves, which drove a “flip this house” culture and shook up banks’ otherwise conservative culture. Higher rates might do much of the work of bringing banks down to earth as any specific regulation or structural reform.)
The problem today is not a lack of stimulus or demand in the economy. Rather, we are in a classic “supply shock” correction featuring simultaneous inflation and a reduction in output. It’s sad that the NY Times editorial on the recent slowdown is largely silent about the causes and, in particular, ignores the fact that we are reaping the rewards of an early “stimulus” policy in the form of extraordinarily cheap money from 2001-2004. They write, in Pavlovian fashion:
The best place to start is by rethinking economic stimulus. When Congress passed the existing stimulus package, gasoline was around $3 a gallon. By the time the rebate checks start going out in May, gasoline is likely to be well on its way to $4 a gallon. At that price, much of the $100 billion or so in rebates will go to fill Americans’ tanks, a bigger boost to nations that sell oil to the United States than to the United States itself.
The next round of stimulus, which Congress should be considering now, must accomplish what the first round neglected. It must focus on bolstered unemployment compensation and bolstered food stamps, ensuring that taxpayer dollars are spent on the neediest and on programs that are proven to spur the most economic activity for every dollar provided. The nation cannot afford more misguided giveaways.
The Carter administration faced the same problem in the late 1970s. Bound by Keynesian analysis, they simply couldn’t make sense of the simultaneous reduction in demand and inflation that signalled the supply shocks rolling in from OPEC and elsewhere. Stimulus packages may win a vote or two, but this kind of response is simply the fiscal equivalent of the loose money policy that Treasury Secretary Paulson and Fed Chairman Bernake continue to embrace in response to the current financial crisis. Neither the NY Times, nor Bernake and Paulson, care to acknowledge that the earlier Fed-driven inflation and the fiscal stimulus of Bush’s deficit spending are largely the reason we are where we are now.
As the old saying goes, when you’re in a hole, the first thing you’ve got to do is stop digging.
Subscribe To This Feed
A lot of this was enabled by China. Its economy is now half as big as ours and its policy of pushing industrial growth at the expense of its citizens standard of living is having a major effect on our productivity and asset values.
They back up our profligate borrowing by lending us money that should go to the Chinese citizens who are creating the wealth. This keeps their people poorer, which pushes them to work harder for less reward, keeps their goods cheaper, and helps push increasing industrialization.
Meanwhile, with Chinese money flooding the U.S. in a disproportionate measure to our true growth potential, the money has to go somewhere. It ends up causing asset inflation, because with the ability to borrow cheaply, we are incentivized to borrow more rather than work more. And when we can borrow too cheaply and easily, we invest unwisely (i.e. ballooning federal spending and home prices).
But at the end of the day an investment has to make sense, and the world is finding out that throwing money at the U.S. isn’t such a fail safe strategy.
Ironically, this could be good for us, as a weakened dollar will allow us to focus on producing more stuff rather than borrowing more money. We are after all, still the world’s strongest and most productive economy, and well worth sensible investing in.