Saturday, April 19, 2008
Intellectual Honesty and Housing
"The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the [Fed] to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street. If instead, we let housing prices fall another 25-30%--as predicted by the Case Schiller House Prices Futures Indexes--it's almost certain that Washington will end up nationalizing the mortgage business. ... Meanwhile, the collapse of house prices and the attendant damage to credit markets have become so severe that the Fed has been forced to create new policy measures at a fast clip, including the radical decision to take $30 billion worth of Bear Stearns' risky mortgages onto its own balance sheet, and to open the discount window to investment banks. ... The monetary easing I'm recommending can occur by having the Fed print money to purchase mortgages directly or purchase Treasury securities directly. The latter is probably more desireable because it adds higher quality assets to the Fed's balance sheet. ... Fed reflation--to slow the fall in home prices and alleviate the distress for households and lenders--carries many risks. ... The Fed should announce its intention to add to its holdings of Treasury securities in order to provide additional liquidity. It should cease pegging the fed funds rate while this policy is in effect. ... While there is a substantial risk that inflation may rise for a time--this would be the policy goal--monetization is more easily reversible than the nationalization of the mortgage market. ... The post-bubble period has yielded some very unattractive policy alternatives. They clearly underscore the rationale for having the Fed target asset prices--in a world where asset markets affect the real economy more than the real economy affects asset prices", my emphasis, John Makin (JM) at the WSJ, 14 April 2008.
I hand it to JM, he's honest about US policy choices: inflate or let Wall Street suffer. JM wrote, "inflation ... would be the policy goal". I'll illustrate. Suppose a house today is "worth" $400,000, i.e., it could be sold for cash to a third party in say 60 days for $400,000. The current "owner" owes a bank $550,000 on the house, having bought it in California 18 months ago. If the "owner" defaults, the bank loses $150,000. Simple enough. Suppose the Fed "gins up" inflation to average 12% a year for the next four years and the current "owner" holds the house. If it's price keeps up with inflation it is worth 157.4% of $400,000 or $629,600 in 2012 dollars. What's happened? The bank can be paid off because the mortgage it held was not inflation adjusted. Who loses? Anyone who holds bonds or savings accounts as they are only worth 63.5% (1/1.574) of their 2008 value. The losses go somewhere. JM's "solution": make those least capable of understanding the losses and who have the least political power bear them. JM's "solution" of trying to "stabilize housing prices and financial markets" reminds me of 1942-51 Fed policy, the "period of the peg". During these nine years the Fed kept long-term US Treasury bond rates "stable" at 2.5%. The peg ended 4 March 1951 with the Treasury-Fed Accord. The US had price controls from 1942-47. Reported inflation from 1942 to 1947 was, by years: 10.97%, 6.00%, 1.64%, 2.27%, 8.43% and 14.65%, http://www.inflationdata.com/, source. The US had an inflationary explosion in 1947 when WWII price controls ended. Consider, with long-term bonds yielding 2.5% all this time, what did they pay in real terms? We are seeing the inflationary explosion now. Overseas. Wait, inflation will be repatriated.