Does The Fed Have The Right Information? Reprinted

The following post is a reprint of my January 4, 2008, post on another, short-lived blog of mine. I am reprinting the post because 3 years later there is still a need for solutions to our economic problems of slow GDP growth and high unemployment and there is still an ongoing debate as to what are the best monetary and fiscal action policies to follow:

January 4, 2008

Does the Fed have the right information?

Does the Federal Reserve have the best information to control inflation and maintain employment growth? Has the Fed been too passive in accepting the current supply of economic data?

The Fed, like the rest of us, relies on published economic data, surveys, and anecdotal evidence to assess the state of the economy, and most of that data reflects past or concurrent economic indicators of the health of the economy. The Fed does not have magical powers or a crystal ball to tell it what will happen next. The Fed does not have a secret recipe that makes it a better predictor of the future of the US economy than ordinary investors. But, the Fed does attempt to maintain a sustainable level of economic growth that will cause neither inflation nor excessive unemployment based on all available information.

In fact, the Fed and many economists look at bond yields, including the slope of the yield curve, and stock market prices to assess future GDP because these prices contain investor expectation data about future interest rates, inflation, and economic growth.

But is the Fed too passive in monitoring the current supply of information. Why doesn't the Fed in conjunction with the Treasury create a government issued financial instrument that would reveal more about the future of the US economy than is currently available?

For example, Treasury could issue a GDP linked bond whose semiannual coupon payment would be a fixed percentage of the most recent nominal GDP number at the time of coupon payment. This would force investors, in pricing the bond, to incorporate explicit expectations about future GDP. The price of the bond would reflect the present value of all future GDP growth over the period until maturity. And because the bond would be discounted (present valued) based on nominal interest rates, the current price would be a measure of total real (inflation adjusted) GDP over the life of the bond.

GDP linked treasury bonds, through analysis of embedded forward rates, would allow the Fed to see in what future time periods over the future life of the bonds that the market was predicting a slow down in economic growth. It would also allow the Fed to see if its policies were merely time shifting future economic growth into other periods without actually creating any overall growth in the economy.

Over time, the premium on the rates paid on these bonds over plain treasury bonds would allow for an analysis of the inherent risk of the US economy. And whether this risk changes over time.

Changes in the price and future embedded rates of GDP linked bonds would allow for an analysis of the effect of legislative and other governmental policies on US future economic growth. If the government introduces or discusses policies and there is an immediate decrease in the price of the bonds then clearly the policies are not good for maximizing future economic growth; although, they may have other benefits.

Having a GDP linked treasury bond would allow the US to maximize future economic growth. The bonds would also allow information about future economic activity to be discerned and assigned to a specific future time period. GDP linked bonds would allow the populace to see if our politicians are doing positive things for the future health of the US economy after their terms in office end before we actually are in those time periods.

The Fed does have very good mathematical economic models to project future economic growth. However, like all models, they work only as long as the relationship among the variables remains static or predictable. So for example, one of the Fed's models mistakenly predicted that we should have been in a recession for the last several years because it used historical relationships about the relative investment in fixed capital versus intellectual property and missed the increase investment in intellectual assets. When correcting the model for the actual relationship between intellectual and fixed property investments over the last several years, the model accurately predicted the actual historical economic growth, but failed on a prospective basis because of the change in the relationship of the variables.

The Fed should take a more active role in deciding what information it can obtain from the investment markets, design instruments accordingly, and work with Treasury in issuing and creating liquid markets for these information designed securities.

A Zero Stimulus Impact

From Economics One blog, "Stimulus Math: Many Multiples of Nothing is Still Nothing" by Stanford economics professor John B. Taylor:

States used stimulus funds to replace their borrowings. Government spending did not increase. How could there be any stimulus effect from these federal funds to states and municipalities if spending at the local level did not increase?

Economic research, from as far back as 1979 by Ned Gramlich, showed that federal stimulus funds substitute for state and local funds with little if any increase in spending.

See John Coogan and John B. Taylor's excellent article on this topic in today's Wall Street Journal, "The Obama Stimulus Impact? Zero: Liberals are still arguing that the federal spending stimulus wasn't large enough. How many multiples of nothing—its result according to new evidence—would they like?"

Dallas Fed: Current Economic Indicators Do Not Eliminate A Double Dip Recession

Economists at the Dallas Federal Reserve Bank discuss why the current economic signals do not eliminate the fear among economists of a double dip recession.

From The Economic Letter—Insights from the Federal Reserve Bank of Dallas, "Gauging the Odds of a Double-Dip Recession Amid Signals and Slowdowns" by Harvey Rosenblum and Tyler Atkinson:

Concerns and Caveats
The yield curve’s steep upward slope suggests a low probability of a recession in the coming year. Nonetheless, many economists are reluctant to rely on this indicator because the curve’s shape and slope have been distorted by the Federal Reserve’s unconventional monetary policy: a near-zero federal funds rate and a quantitative-easing program that damped intermediate- and longer-term Treasury rates. With near-zero short-term rates, it is almost impossible for a yield curve inversion, that is, short-term rates exceeding longer-term ones.

There is some reason to believe the unemployment rate could climb again. Claims for jobless benefits remain at a level usually associated with an increasing unemployment. Even if the rate does not increase, it remains elevated, straining the overall recovery.

While the current real price of oil does not fit the criterion of a shock, it sits at levels only seen in the early 1980s and 2006–08. An oil supply shock would be especially damaging to the already weak recovery.

Most forecasters project growth at 2 to 3 percent over the next year, but not gaining sufficient momentum to advance safely above stall speed. Until this situation is resolved, policymakers will continue facing pressure to pursue fiscal and monetary measures to guide the economy toward full employment and more robust growth.

.Read the complete Economic Letter here.

New Economic Research Finds Tax Cuts And Not Stimulus Spending Promote Economic Growth

From "Why the Spending Stimulus Failed: New economic research shows why lower tax rates do far more to spur growth." by Michael Boskin in the Wall Street Journal:

economic theory, history and statistical studies reveal that more taxes and spending are more likely to harm than help the economy. Those who demand spending control and oppose tax hikes hold the intellectual high ground.[Emphahsis Added].
***Macroeconomics since Keynes has incorporated the effects of longer time horizons, expectations about future incomes and policies, and incentives (including marginal tax rates) on economic decisions.***based on the best economic evidence, we should reject increased spending and increased taxes.

If anything, we should lower marginal effective corporate and personal tax rates further (for example, along the lines suggested by the bipartisan deficit commission's Erskine Bowles and Alan Simpson). We should quickly enact an enforceable gradual phase-down of the spending explosion of recent years.

Read the complete Wall Street Journal article here.

1 Out Of 2.5 Households Were Unemployed, Had Negative Home Equity Or Were Behind In House Payments Between November 2008 And April 2010

the effects of the recession are widespread: between November 2008 and April 2010 about 39 percent of households had either been unemployed, had negative equity in their house or had been in arrears in their house payments. Reductions in spending were common especially following unemployment.

From "Effects of the Financial Crisis and Great Recession on American Households" by Michael D. Hurd, The RAND Corporation; SUNY at Stony Brook University, College of Arts and Science, Department of Economics; National Bureau of Economic Research (NBER) and Susann Rohwedder, The RAND Corporation.

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The US Economic Recovery Is Worse Than Other Countries

From "Echoes of the Great Depression" by Phil Gramm:

The chart nearby compares total 2007 employment levels in the United States, the United Kingdom, the 16 euro zone countries, the G-7 countries and all OECD (Organization for Economic Cooperation and Development) countries with those of the second quarter of 2010. There are 4.6% fewer people employed in the U.S. today than at the start of the recession. Euro zone countries have lost 1.7% of their jobs. Total employment in the U.K. is down 0.6%, G-7 average employment is down 2.4%, and OECD employment has fallen 1.9%.

Most striking about these comparisons is their similarity to the U.S. experience in the Great Depression. Using data from the League of Nations' World Economic Survey, we can look at unemployment in developed nations between 1929 and the end of 1938. Ten years after the stock market crash, total employment in the U.S. was still almost 20% below the pre-Depression level. The decline in France was similar. But in the U.K. and Italy, total employment was up 10% and 12%, respectively. Industrial production on average in the six most developed countries was almost 16% above their 1929 levels by the end of 1938, but industrial production had declined by 20% in the U.S.

Today's lagging growth and persistent high unemployment are reminiscent of the 1930s, perhaps because in no other period of American history has our government followed policies as similar to those of the Great Depression era. Federal debt by the end of 1938 was almost 150% above the 1929 level. Federal spending grew by 77% from 1932 to 1934 as the New Deal was implemented—unprecedented for peacetime.

Read the complete article here.

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CBO Elmendorf: Presentation to Macroeconomic Advisers: Fiscal Policy Choices in Uncertain Times

From CBO Director Doug Elmendorf's presentation to Macroeconomic Advisers, "Fiscal Policy Choices in Uncertain Times" on September 16, 2010:

• The economic recovery will probably proceed at a modest pace—leaving total output well below its sustainable level, and the unemployment rate well above its sustainable level, for a number of years.


• In CBO’s judgment, the available monetary and fiscal tools, if applied at sufficient scale, would improve economic conditions during the next few years—though with costs and risks in the medium and long term. Policymakers need to address those trade-offs.


• To avoid worsening the medium-term and long-term imbalance between federal spending and revenue, any policies that widened budget deficits in the near term would need to be accompanied by specific polices to reduce spending or increase revenue over time.

Read the CBO director's complete presentation here or below.
Elmendorf Fiscal Policy Choices in Uncertain Times

Elmendorf Fiscal Policy Choices in Uncertain Times

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Regulatory Arbitrage Did Not Cause The Current Banking Crisis

Banks Need Adjustable Capital Amounts Sensitive To Future Economic Conditions

Regulatory capital ratios capture firm specific events but do not capture economy wide events. Regulatory arbitrage did not cause the current banking crisis and its complete elimination would not prevent a repeat of the current banking crisis.

Regulatory capital is set by lending and investment categories, such as mortgages, but the computed capital ratio is formulaic, static and does not vary by regional or US economic conditions. Additionally, it is in part dependent on outside ratings by credit rating agencies, especially SEC approved NRSROs, which are lagging indicators of changing riskiness and default rates instead of leading indicators.

Holding $100 million of residential mortgages outright or holding the same dollar amount of securitized residential mortgages does not change the risk the institution faces. The regulators compute regulatory capital by form instead of the substance of the asset, and the institution can free up required capital by modifying the form of its holding and use the extra capital to increase its holdings and concentration in that asset, i.e. engage in regulatory arbitrage. Effectively, the increase risk comes from increased leverage and loss of diversification through an increase in a particular asset concentration.

Additionally, since regulatory capital ratios do not change to reflect changing economic conditions, the regulators require banks to hold the same amount of regulatory capital in growth as in recessionary economic times. We know asset default risk is not constant and changes based upon different regional and US economic conditions, e.g. during periods of higher regional unemployment, regional residential mortgage default rates will increase. Similarly, area home values decline during regional economic downturns and the decline in value increases an area's mortgage default rates.

High unemployment rates along with a substantial decline in home values are the cause of the high mortgage default rates. A lingering, worsening recession was the underlying cause.

There are areas of the US where the decline in home values is 20-50 percent from their highs. In many areas of the US, unemployment is at 25-year highs, if not higher. If banks did not arbitrage from direct holdings of residential mortgages into securitized mortgages, banks would still face substantial write-downs. Residential mortgage defaults would still be higher than usual or expected (by capital set aside) due to substantial home value declines and high unemployment.

Weak US and regional economic conditions and their effects severely affected the value of all residential mortgages and their default rates. It is extremely likely that banks would need to raise capital, face heightened regulatory scrutiny and increased risk of government takeover independent of the form of their mortgage holdings. Even if we had restricted the amount of residential mortgage holdings of any form prior to this economic downturn, the banks would have invested their funds in other earning assets, such as credit cards, commercial loans or commercial real estate. All loans face higher default rates in bad economic times and just about all assets lose value.

What we need is a more sensitive, adjustable capital ratio to future economic conditions. Requiring capital based on sensitivity analysis (stress tests) requires banks to hold more capital than necessary in good times, acts contra-cyclically by restricting lending in good economic times, and lowers the earnings of banks.

Since economic forecasting of turning points in the economy is notoriously poor, market based solutions, such as market valued balance sheets, are probably the best but they are not fool proof. Market values of long-term assets, such as mortgages, reflect all expected losses including those several years in the future. The market value accelerates the future expected default into the present. For example, suppose an apartment building has a 20-year balloon mortgage with a constant yearly interest payment. The likelihood of default during the early years of interest payments may be quite low, but the market may have high expectations of default at the end of the twenty years on the final balloon principal payment. The market could easily value the mortgage at 60 to 70 percent of its face value. The discounted value would force the bank to either increase its current capital base or decrease it lending. The bank would feel the effect of the future default now, many years before it would realize the default and be necessary for it to replenish its capital base. Asset based market valuations for long-term assets could affect lending and investment in a counter-cyclical fashion.

One would have to rerun recent banking history under an alternative, proposed regulatory structure and reconstruct a bank's new balance sheet. We could see, based on new, proposed restrictions, prior to going into this recession, if there is anything that would be different now under a different set of rules and if the banking industry could have avoided its current crisis by lending and investing differently.

Home Values Were Not In A Bubble

Houses are like other assets that are bought and sold in a marketplace. The prices of the transactions in the housing market reflect the economic value to the buyers and the sellers and value is based on future expectations about the economic fundamentals of housing.

In the US and worldwide there has been a noticeable decline in the value of homes. Some argue that home prices were artificially inflated due to a "bubble." Others believe in efficient markets and that the decline in home values is a rational response to a change in economic circumstances and expectations.

Houses are a multi-generational asset in that they are a consumer durable that can been passed on from one generation to another. In a rational expectations, efficient market world which is the world economic research finds we live in, house price changes are due to changes in the expectations of the economic fundamentals related to the need, demand and value of houses. Thus, current house prices reflect their true economic value and homes are not undervalued whether due to the unavailability of credit or for other reasons. Arms-length housing market transactions, of which there are still many, occur at the true current price of housing.

Much recent academic work supports the idea that a sharp price rise and decline in "bubbles" is actually a rational economic response and markets are efficient even in so called "bubbles". For example, see the Wikipedia article on tulip mania and a 2004 article in Slate, Bulb Bubble Trouble [Weblink updated].

So, instead of trying to use government money to artificially shore up house prices, a more rational response to the decline in the value of homes, is to ask what is the price change in the housing market telling us about the future value of housing and to see if that is something that is undesirable. If the expected outcome is not what we would like to see happen and is changeable, then we should do the things to change that outcome in our economy.

Some of the possible future scenarios which would decrease the current value of a home are:

1. a significant and long-term decline in household formation.
2. a significant and long-term decline in population growth in the US due to changes in birthrate or immigration policies.
3. an increase in adult children living in their parents home (including after marriage or cohabitation).
4. an expectation of an increase in mortality or a shortening of life expectancy due to war, disease or natural or man made disasters.
5. a change in our preferences so as to prefer multi-family or apartment type dwellings as opposed to single family homes decreasing the need for single family homes.
6. a significant increase in the costs of owning and maintaining a home which lowers its economic value to a purchaser because of the expected increase cash outflow during ownership.
7. a decline in both household income or the expected growth rate of household income.
8. an alternative technology for building homes which will dramatically reduce the costs of building new houses.
9. a change in home related taxation such as a denial of mortgage interest or real estate taxes deductions.
10. a substantial expected increase in real estate taxes.
11. other possibilities that affect the economic value of a home that I have not mentioned.

Some ideas mentioned above are testable. For example, I was going to mention global warming but a recent paper about house price declines in California observed that the decline is greater in central California than along the coast which is contrary to what would happen to house prices along the coast due to rising sea levels due to global warming. See the paper by OFHEO, "Recent Trends in House Price", pages 4 and 5 and note 6 at http://www.ofheo.gov/media/research/pricesandfinancing.pdf [The Office of Federal Housing Enterprise Oversight (OFHEO) no longer exist and I am unaware of an updated weblink to the paper.]

The point of this post is that to most economists who believe in economic value, efficient markets and rational expectations, the current decline in home prices is a rational response to a change in expectations about the value of homes. If there were not this belief that current homes are fairly valued, then buyers would be buying up and warehousing the depressed priced homes, the foreclosed homes and abandoned homes. The fact that buyers are not rushing in shows that the current prices of homes are fair and homes are not undervalued.