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Bernanke Agonistes

Every Chairman of the Federal Reserve Board of Governors in the "modern" era (beginning with the forced appointment of Paul Volcker by Jimmy Carter in 1979, since which time the Chairman has exerted his independent authority) has faced a crisis. Volcker's was simply beating back the squawking politicians as he took the drastic but necessary steps to clean up the financial mess the '70s had become.

Greenspan faced the huge uncertainty over the "Millennium bug" or "Y2K." That the fears of worldwide meltdown over computer programs unable to register the new date were vastly overblown was entirely irrelevant. In the markets, problems most often occur not because of what happens, but rather due to the fear of what might happen. Greenspan acted to alleviate fears over what might happen to the banking system by flooding the economy with liquidity. It worked. (That he later may have triggered a mild recession by trying to squeeze the excess cash out of the system too quickly was a small price to pay for avoiding a panic).

Now it's Ben Bernanke's big test, as the fears of high default rates in the subprime mortgage sector have spooked financial markets. The Dow Jones Industrial Average, the NASDAQ composite, and the Standard & Poor's 500 index have all lost 10% of their value over the last 30 days. For perspective, the DJIA lost 17% of its value in the 30 days preceding Black Thursday in 1929.

The first question Bernanke must resolve, of course, is whether or not to intervene.

There are good arguments for both courses. In favor of standing pat, we have the fundamentals. The economy is strong, growth is steady, even basic materials are rebounding well (usually a sign that construction will follow). Inflation is well contained. Consumer spending hasn't plummeted as some had feared. The current crisis resulted from the overly optimistic actions of some borrowers, lenders, and investors, and they ought bear the brunt of their foolhardiness. In this camp of the Reaganesque "Don't just do something - stand there!" falls the estimable George Will, writing in the Washington Post:


But this, too, is true: Every improvident loan requires an improvident borrower to seek and accept it. Furthermore, when there is no penalty for folly -- such as getting a variable-rate mortgage that will be ruinous if the rate varies upward -- folly proliferates. To get a mortgage is usually to commit capitalism; it is to make an investment in the hope of gain. And if lenders know that whenever they go too far and require inexpensive money the Federal Reserve will provide it with low interest rates, then going too far will not really be going too far.

In 2008, as voters assess their well-being, several million households with adjustable-rate home mortgages will have their housing costs increase. Defaults, too, will increase. That will be a perverse incentive for the political class to be compassionate toward themselves in the name of compassion toward borrowers, with money to bail out borrowers. If elected politicians controlled the Federal Reserve, they would lower interest rates. Fortunately, we have insulated the Federal Reserve from democracy.

The Federal Reserve's proper mission is not to produce a particular rate of economic growth or unemployment, or to cure injuries -- least of all, self-inflicted ones -- to certain sectors of the economy. It is to preserve the currency as a store of value -- to contain inflation. The fact that inflation remains a worry is testimony to the fundamental soundness of the economy, in spite of turbulence in a small slice of one sector.


The whole article is at the link above. I would only disagree with the last statement that the Fed's mission is "to contain inflation." A better description of the FRB's duty is "to ensure adequate currency to the economy without igniting inflation." While the modern-era strong Chairman was born of runaway inflation, and containing it has certainly been the goal ever since, we do and should tolerate inflation at low levels because it always beats the alternative - but that's another post. The primary mission is to ensure adequate currency.

There are several ways the FRB could act to counter the market panic without necessarily bailing anyone out. They could, of course, lower interest rates, which are probably a bit on the high side now (in keeping with the self-image of the Fed as inflation-fighter). They could also buy the sound private bonds on the market as a symbol of trust - the good loans aren't going south, and the subprime mortgage defaults constitute only a tiny proportion of the home mortgage market. This would undoubtedly allay much of the fears.

Lastly, they could amend the regulations to foster more private capitalization by loosening restrictions. "Whoa, there," you might say, "why would we react to over-optimistic financing by further loosening?" It may seem counter-intuitive, but that's the way markets function. Resources flow naturally to their most efficient use; regulations often obstruct the flow.

On this side of the question stands Larry Kudlow of National Review:


Economists David Malpass and John Ryding at Bear Stearns believe second-quarter GDP will be revised up from 3.4 percent to over 4 percent, while third-quarter GDP will come in at a minimum of 2.5 to 3 percent. So, despite the fact that stocks have hit an air pocket and credit markets are suffering a temporary power outage (to borrow a term from economist John Rutledge) the country is not plunging into recession.

That said, the financial liquidity squeeze triggered by the sub-prime virus is a very difficult near-term problem.

Everyone's watching the Fed, and markets are strongly signaling a Fed ease. Supply-sider Paul Hoffmeister, chief economist at Bretton Woods Research and a former staffer to the late Jude Wanniski, believes a Fed ease would help spur economic growth. What's more he thinks the added liquidity will bring more bidders to the mortgage credit market, while added growth at the margin will mop up some of the inflationary pressures visible in $670 gold.


Read it all at the preceding link. The danger of doing nothing lies with the herd mentality of markets in stampede mode. Many sound financial institutions could be swept up in the crisis of confidence even though they maintain a strong portfolio with a low and acceptable level of "problem loans." That wouldn't be good for the economy in either the long or short run.

I tend to agree with Kudlow that some action is called for. While Will also makes sound points, there is no benefit to watching the house burn down if pumping some water could save it.


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Comments (13)

I'm for minimal involvement... (Below threshold)

I'm for minimal involvement. This sub-prime mortgage crisis has happened a number of times, and a Fed bailout will only encourage the practice to continue. Do only what is absolutely necessary.

"to ensure adequat... (Below threshold)
_Mike_:
"to ensure adequate currency to the economy without igniting inflation"

Well put. Out of curiosity, from where did the quote come ?

=======
To the question, what should the government do to help ? I say, "laissez nous faire".

The default rate is due to overly aggressive lenders loaning money to overly aggressive borrowers not a widespread loss of jobs. If the government (i.e. we) bail them both out, there's no downside to being 'overly aggressive'. It's time for the children to deal with the consequences of their actions on their own.

When you read stories about... (Below threshold)
DJ:

When you read stories about individuals getting 600K mortgages on 25K salaries, you have to wonder (example) what the hell lenders were thinking.

Sure, responsibility ultimately lies with the individual signing the paper, but good grief, this "crisis" was entirely avoidable with a little personal responsibility. The lender shouldn't have pimped the loan, and the buyer should have had the common sense to know they couldn't afford it.

Its like buying a Ferrari and then having to park it because you can't afford the licensing or the maintenance.

We don't have to "bail out"... (Below threshold)

We don't have to "bail out" anyone - and shouldn't. Democrats - notably Hillary Clinton, quoted in the Will article - would be inclined to bail out the borrowers, who were marginal at best to begin with.

However, if the market panic over what does amount to a tiny fraction of loans impacts the entire mortgage market, the repercussions will echo far beyond the subprime lenders and borrowers. If a child set a fire by playing with matches, we wouldn't let the whole house burn down just to teach him a lesson, because that would impact the rest of the family, who were blameless.

The steps I outlined don't amount to a "bailout" of anyone - although, as Will fairly notes, lowering interest rates would help the guilty as well as the innocent. The joys of schadenfreude notwithstanding, it seems a bit perverse to see the good paper burn up with the bad.

I think NY has already comm... (Below threshold)

I think NY has already committed a boatload of cash to 'help' people convert their adjustables to fixeds. Part of me says 'screw that' and the other part says it's not a bad idea. That said, I bought a house recently on a fixed...think I'm gonna get anything for doing the smart thing to begin with? Yeah right.

Any action by the Fed will ... (Below threshold)

Any action by the Fed will only increase the likelihood that in 2-3 years we'll have another crisis in banking and another call for a bailout. The banks knew that they were loaning money to people who were unable to repay the loan, but they loaned money based on an expectation of endless increases in the price of houses. Any halfway decent economist knew that the pattern of 15-50% increases Year-over-year in housing prices was not sustainable. And there never was a reason to go away from the 3X salary max house value that banks used for years to determine a borrowers ability to repay a mortgage.

The fed should do nothing and let the market fix ths problem itself.

However, if the m... (Below threshold)
_Mike_:
However, if the market panic over what does amount to a tiny fraction of loans impacts the entire mortgage market, the repercussions will echo far beyond the subprime lenders and borrowers.

When you decide to build a bon fire in your living room (again), it makes no sense for others to waste resources to save your house (again) - to do so simply encourages you to engage in further careless behavior and will result in a future waste in resources. Note, that's not the same as advocating that the resources shouldn't be expended to prevent the fire from spreading to other houses.

As you stated, the FRB's responsibility is to insure sufficient liquidity exists. What's the consequence of providing excess liquidity (see the years before and after 2000 for one example). Is the current crisis the result of insufficient liquidity ? Why, then, should the solution be to provide more if it's not a 'bailout' ?

And it's not schadenfreude that's behind my position. It's the belief that the long term solution doesn't involve saving people from the consequence of their own obviously poor decisions.

But, Mike, if you burn down... (Below threshold)

But, Mike, if you burn down your house and the fire threatens your neighbors' homes, too, shouldn't they consider "wasting" some water to prevent that?

Or we could just Schumer "solve" the problem by creating new ones.

Not to get too off-topic, b... (Below threshold)
jpm100:

Not to get too off-topic, but the tumble in the Stock Market also coincides with the passage of the Energy bill (aka Greenhouse Gas bill (aka Gas Tax)).

I think the gridlock the stockmarket wanted is poised to crumble.

As you stated, the FRB's re... (Below threshold)

As you stated, the FRB's responsibility is to insure sufficient liquidity exists. What's the consequence of providing excess liquidity (see the years before and after 2000 for one example). Is the current crisis the result of insufficient liquidity ? Why, then, should the solution be to provide more if it's not a 'bailout' ?

The current crisis is the result of a previous state of excess liquidity pushing the market into an imbalanced position. After the dot-com bubble burst there was too much money looking for investment opportunities and many investors wanted to stay out of a stock market they no longer trusted. Money poured into mortgage backed bonds and derivatives. This provided additional capital to banks which they then used to loan to people purchasing homes.

As you can guess, house prices started to skyrocket which only served to feed the flame as more and more money was poured into real estate. Yhe danger always was that once all the excess liquidity in the market was absorbed there would be a shortage of buyers for all of the available homes, and too many people borrowed money on the assumption that in 2-3 years they would sell their home at a profit and be able to repay loans they could not afford. Even the banks assumed that prices would rise indefinitely.

Well, the liquidity is now gone and prices are correcting back to saner levels. Unfortunately there are some people who are going to get burned, but the vast majority of those who are facing foreclosure knew that it was a risk when they purchased the house. They took out a loan they could not repay based on the belief that they could profit from the sale of the house. To bail them out is to reward their greed and the greed of the banks that loaned them money on that same assumption.

There should be no bailout by the government.

Jim Addison:<blockqu... (Below threshold)
_Mike_:

Jim Addison:


But, Mike, if you burn down your house and the fire threatens your neighbors' homes, too, shouldn't they consider "wasting" some water to prevent that?

perhaps you missed this in my previous post:

Note, that's not the same as advocating that the resources shouldn't be expended to prevent the fire from spreading to other houses.

Jim Addison:

Or we could just Schumer "solve" the problem by creating new ones.

Nah, that'd 'Schumer' it up really good.

see my previous post (poor grammar and all):

To the question, what should the government do to help ? I say, "laissez nous faire".


Always thought adjustable m... (Below threshold)

Always thought adjustable mortgages (and the new trick, 'interest only' mortgages) were bad ideas. With the interest only mortgage you might just as well be renting - you're not building equity in the house unless you're counting on your house appreciating significantly - and if it doesn't, you're SOL.

If the rates come down far enough, we might refinance from our 30-year fixed to a 15-year fixed rate loan. But we wouldn't do an adjustable or interest only...

Mike ~ Yes, I missed that i... (Below threshold)

Mike ~ Yes, I missed that in your previous post, and I apologize.

I think the markets have overreacted - as per usual - and the liquidity crunch is clearly spreading beyond the narrow range of those who fund subprime mortgages with high default rates. T-bill yields have dropped about a full point in the last week, indicating tons of money fleeing equities into the safety of bonds.

Clearly we have at least a crisis of confidence, and panic threatens. This is one of the reasons we have an FRB in the first place.


JLawson ~ ARMs are certainly a gimmick, invented in the '80s to cover liquidity shortfalls in housing then, along with other "creative financing" techniques like balloon payments and interest-only mortgages. All of these were designed as short-term solutions for otherwise qualified buyers willing to gamble on the US economy righting itself before they were squeezed. Applying such instruments to subprime borrowers was an accident waiting to happen.

None of the losers in this subprime market are innocent bystanders. All of them took on large risks for the potential of large rewards, and "risk" means nothing at all if you can't lose the gamble because government will bail you out. My concern is for the innocents who will be immolated by the back-draft created, and for the health and balance of the economy as a whole (to ensure continued growth going forward).




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