What Can Be Done to Hasten the Recovery?

I believe the Fed can and should be doing more to create a more stable macroeconomic environment.  There is much they can yet do to stabilize aggregate spending and improve economic certainty.  However, even if we were to get this from the Fed it still would not solve all our economic problems. We are in the midst of a massive deleveraging cycle by households and unless something radical happens like swapping  the underwater portion of household mortgages for equity  this process will probably take years to unfold. Ken Rogoff reminds us of this point in a recent article:

What more, if anything, can be done? The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.

The only palliative he sees is higher inflation:

Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation. While the Fed is still reluctant to compromise its long-term independence, I suspect that before this is over it will use most, if not all, of the tools outlined by Bernanke.

I too don't want to comprise the Fed's long-run inflation credibility.  That's why I want a NGDP  level target (my first choice) or price level target (my second choice... I really don't like this one but I will settle for it). It would create some higher (catch-up) inflation until we hit some target level and stabilize thereafter. If this policy were made explicit it would do much to stabilize economic expectations, a big plus in our current mess.  Again, this will not fix our structural problems, but it would create a more stable macroeconomic environment in which to make the needed structural adjustments.  Now if we could get more discussion on  proposals to hasten the restoration of household balance sheets, such as the one to swap underwater mortgage debt for equity, maybe the structural adjustments could  be expedited too.

Barry Ritholtz on the Origins of the Financial Crisis

The summary:

The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings -- these are the key to how we ended up in the current crisis.

Read the entire piece here. See Ritholtz's earlier discussion of these developments here.

Share of Home Mortgage Market

Below I have reproduced the figure first made by Jim Hamilton and Richard Green and then later popularized by Mark Thoma. This figure suggests the following: (1) Fannie and Freddie (the GSEs) gained market share beginning in the 1980s from the saving institutions (presumably from the Saving & Loan debacle fall out); (2) Fannie and Freddie lost market share beginning around 2002 to the asset-backed security issuers. As noted by the above observers, this latter point supports the notion that at least some of the problems at Fannie and Freddie emerged in response to their declining market share during the housing boom. In other words, what happened to Fannie and Freddie may have been a symptom rather than a cause of the housing boom-bust cycle. (Click on figure to enlarge.)

Source

Update: This article from the National Journal argues that Fannie and Freddie played a larger role than I outline above.

Charles Calomiris: The Perfect Finanical Storm

Charles Calomiris gave a paper at the Jackson Hole meetings on the current housing boom-bust cycle. Calomiris argues in the paper that the simultaneous occurrence of two "longstanding incentive problems" and two "unusual historical circumstances" gave rise to the perfect financial storm we now know so well.

From the paper:

The longstanding problems were (1) asset management agency problems of institutional investors and (2) government distortions in real estate finance that encouraged borrowers to accept high leverage when it was offered. But these problems by themselves do not explain the timing or severity of the subprime debacle. The specific historical circumstances of (1) loose monetary policy, which generated a global savings glut, and (2) the historical accident of a very low loss rate during the early history of subprime mortgage foreclosures in 2001-2002 were crucial in triggering extreme excessive risk taking by institutional investors. The savings glut provided an influx of investable funds, and the historically low loss rate gave incentive-conflicted asset managers, rating agencies, and securitisation sponsors a basis of “plausible deniability” on which to base unreasonably low projections of default risk.

I find myself in agreement with Calormiris' take on the origins. I especially like his argument that loose monetary policy created the global saving glut, not the other way around as argued by many observers. Calomiris also discusses the Fed's response to the crisis. He argues the Fed's "surgical" strikes (e.g. Bear Sterns) prevented a meltdown of the financial system, but its low fed funds rate policy has been eroding the Fed's inflation-fighting credibility. He also discusses some reforms going forward. Finally, the paper has a lot of interesting financial history in it. Collectively, these various parts make the paper a good supplement to a money and banking class. I plan to use it this fall in my classes.

You can the entire paper here or view a summary of it here.

Two Paths for Housing Prices

Here are two studies that come to vastly different conclusions on future declines in home prices. First up is the study by Charles W. Calomiris, Stanley D. Longhofer and William Miles. Titled "Housing Turmoil", this study looks at the relationship between foreclosures and home prices. These authors find that,

[e]ven under an extreme worst-case scenario for foreclosures,... U.S. house prices just aren't going to fall by very much in the next two years. In our worst-case scenario, the average cumulative decline is about 5 percent, and only 12 states experience declines greater than 6 percent by the end of 2009.

They conclude that "declines in house prices are highly likely to remain small.... [A]s foreclosures continue to climb in many states, house prices will remain flat or decline in those states -- but will not collapse."

Next up is Vladimir Klyuev in his study "What Goes Up Must Come? House Price Dynamics in the United States." He finds the following:

In the last few years, home prices had risen to unsustainable levels and then started to decline. In this paper we use a variety of techniques to assess the current extent of overvaluation. We put the most stock in the estimate based on a cointegrating relationship between the price-rent ratio and the real interest rate, which is quite robust to the choice of the sample period. According to these estimates, home prices were undervalued in the 1990s, but overshot equilibrium in 2000 and remain overvalued despite recent declines. In our best judgment, single-family home prices as measured by the OFHEO purchase-only index were around 14 percent above equilibrium in the first quarter of 2008, with a plausible range of 8 to 20 percent.

In other words, home prices may still have some ways to go. So which study is right? I find the latter study more reasonable, but I may be--and hope I am--wrong. Today's NY Times story on bigger waves of upcoming mortgage defaults from Alt-A and Prime mortgage (i.e. the good and supposedly safer mortgages) only seems to confirm Klyuev's finding. Thankfully, Arnold Kling , helps puts this housing debacle into a long-run perspective that is not so dour.

How Big is the Current Financial Crisis?

So how big is this financial crisis and how does it compare to other crises of the past? I have already alluded to the $1 trillion dollar estimate of Charles Morris. Elsewhere, Mr. Morris has said this estimate is a conservative one since it assumes an orderly unwinding in financial markets. This conservative estimate is consistent with Nouriel Roubini who makes a low-end estimate of financial losses at 1$ trillion. Martin Wolf discusses several estimates that go high as $3 trillion. He notes the following:

Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since the 1930s. It would be an epochal political event.

Such high-end estimates are alarming. Now the IMF is weighing in on the matter. It has released its Global Financial Stability Report which shows estimated financial losses coming in just under $1 trillion. It also provides an interesting graph comparing these losses with previous financial losses:

Note that the IMF figure for the current financial crisis is based on the problems with subprime mortgages. As Charles Morris explains, though, the "subprime [crisis] is just the first big boulder in an avalanche of asset writedowns that will rattle on through much of 2008...Expect the landslide to cascade through high-yield bonds, commercial mortgages, leveraged loans, credit cards and -- the big unknown -- credit-default swaps." Figuring in these latter developments leads to the higher estimates of $2-$3 trillion dollars.

Someone asked me this past weekend how bad this recession will be going foward. Taking the consensus view, I said it would be mild and over by the end of 2008. Thinking about these estimates of financial losses, especially the higher-end ones, is making me less certain of that claim. For the same reason, Nouriel Roubini says the consensus view of when the recession will end is in fact wrong. I hope he is wrong.

Update
In a Bloomberg article discussing the expected $1 trillion loss put out by the IMF, this sobering fact is stated: "The [IMF] forecast signals the worst of the credit crunch may be yet to come, because banks and securities firms so far have posted $232 billion in asset writedowns and credit losses."

How Low Will Home Prices Go?

This is a question I keep asking myself, not as an economist but as a potential homebuyer. As I have discussed previously on this blog, I recently moved to Texas from Michigan and am now looking to buy a home. A few weeks ago my wife and I aided and abetted the housing recession. Yes, we are guilty as charged of withdrawing an offer we had on a home under the assumption that the housing market has not hit bottom (there were some other factors as well). It is almost surreal to think I am a part of a downward deflationary spiral in the housing market where expectations play an important role. Of course, the Texas housing market is not the same as the Michigan housing market--where I had to bring money to the table to sale my home--and so I need to be careful in assessing how far home prices will fall here.

Still, I ask how far will home prices fall? The S&P/Case-Shiller house price index for select metropolitan areas and the OFHEO national house price index just came out for the end of 2007 and both show on-going declines across the nation. Below is a graph of the these two (nominal) series in year-on-year growth rate form through the end of 2007.

While this graph is interesting, it does not really provide any insight into my question of how low will house prices go. If we look at the series in the levels we get the following graph:

This figure shows in nominal terms that the home prices reached a peak in late 2006 (Case-Shiller) or early 2007 (OFHEO). The figure also indicates there is much more correction needed for nominal house prices to return to pre-2003 trend levels. This simple 'eyeball' analysis is consistent with what Calculated Risk has reported about futures data on housing prices:

... futures data is forecasting a price drop of 11% over the next year, and close to 25% over the next 3 years for the 25 largest MSAs.

As a home buyer, though, I am also sensitive to mortgage rates and recently they have been going up (see this picture over at the Big Picture). The Wall Street Journal explains why this is happening despite ongoing policy rat cuts:

There are two reasons mortgage rates haven't responded more to the Fed's rate cuts. One is that long-term Treasury yields, which are the benchmark for most mortgage rates, have risen recently, perhaps because of increased concern about inflation as the prices of oil and other commodities soar. The other is that the spread between mortgage rates and Treasury rates has widened as investors and banks become increasingly reluctant to make home loans.

The only way for long-term rates to fall now is for there to be more bad economic news. That would help with the inflation concerns, but it would not eliminate the mortgage-Treasury spread. If the Nouriel Roubini's of the world are correct, and if the mortgage-Treasury spread does not dramatically change, then lower mortgage rates await me in the near future.

So, patiently I wait for further housing price declines and more bad economic news.

Update

James Hamilton discusses the latest housing price data over at Econbrowser.

Greenspan's Reputation is Under Fire for Past Monetary Profligacy...

So says a Bloomberg article.

"Hailed as perhaps the greatest central banker who ever lived when he left the Federal Reserve in 2006, Greenspan is under attack from critics ranging from the New York Times to economists at the American Enterprise Institute for his handling of the 2000-2005 housing boom... Critics blame his aversion to regulation and reluctance to use interest rates to puncture asset bubbles for the boom in mortgage lending and house prices that has since gone bust, threatening to throw the economy into recession...

Some economists, including [Alan] Blinder, also fault Greenspan for fostering the housing bubble by keeping interest rates too low for too long. The Fed cut its benchmark rate to a 45-year low of 1 percent in June 2003, held it there for a year, then raised it only gradually, in quarter-percentage-point increments... A simulation by Stanford University professor John Taylor suggested that much of the housing boom could have been avoided if the Fed hadn't cut rates so deeply and had raised them back up more quickly. [Alan]Meltzer said that while Greenspan was a ``great Fed chairman,'' he erred in ignoring warnings about the risks of keeping rates low. ``I think he lets himself off much too easy,'' Meltzer said, adding that he told Greenspan at the time that he was exaggerating the danger of deflation and thus making a mistake in cutting interest rates to 1 percent."

If this all sounds familiar then you may be a regular reader of this blog (see here, here, here, and here). The Bloomberg article reminds me of the great song "The Bubble Man" by Scott Peterson.

Why the U.S. Needs A Recession to Correct Global Imbalances

I have argued in previous postings that past monetary policy profligacy in the United States has contributed to the global imbalances (here, here, here, and here). Here is an article by Gilles Saint‑Paul that takes a similar view and follows this line of reasoning to its logical conclusion: the current easing by the Federal Reserve puts off the correction of these imbalances--and allows them to continue to build--until a later time when correcting them will be more painful.

It is refreshing to see a thoughtful article on global imbalances that does not bow at the altar of the 'saving glut' goddess. This article takes seriously the 'liquidity glut' view of global imbalances and shows why the conduct of monetary policy for the world's reserve currency can be distortionary for the global economy.

Update: Saint-Paul mentions Volker's recessions in the early 1980s. See here for comments on this experience

Update II: Bill C at Twenty-Cent Paradigms cautions us not to put too much faith in the ability of monetary policy to correct the global imbalances.

How the US imbalances can be corrected
Gilles Saint‑Paul

There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.

This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences. In 2001, the Fed engaged in a policy of drastic reduction of interest rates, for fear that the conjunction between the end of the so-called “Internet bubble” and the attacks of September 11 would drive the US economy into a recession. These considerations were compounded by the increasingly popular view that inflation was no longer a problem. The strong expansion of the late 1990s had been accompanied with little inflationary pressures and there were fears that the deflationary experience of Japan might hit the United States.

The result of these policies is that the US was in a regime of very low real interest rates. From 2002 to 2004, the federal funds rate did not exceed some 1.5 %, while inflation moved from 1.6 % to 2.7 % during that period. Thus short-term real interest rates were clearly negative. As for longer maturities, some real rates fell to 1.5 %. Many would argue that this was the right thing to do; GDP stayed at its potential level, or below it, and the incipient increase in unemployment was reversed.

The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.

One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.

The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high. In fact, when interest rates fall below the growth rate, assets become impossible to price. Consider, for example, a share that pays a dividend which grows at 5 % a year. With a 2% interest rate, it is profitable to buy that asset regardless of its price, because I only need to hold it for a sufficiently long time for the dividends to eventually exceed the interest payments. So the price of the asset is in principle infinite. In fact, people do not live forever, so they will have to sell the asset back at some point; but one can show that any change in markets' expectations about that future price can be validated by a corresponding change in the current price—so, the current price can be anything.

In particular, low interest rates may start asset bubbles. One mechanism is as follows. As the price starts rising due to lower interest rates, irrational speculators start buying the asset on the grounds that the price increases are going to continue. That fuels the price increase which may eventually develop into a bubble where all speculators, including the rational ones, pay a high price for the asset because they expect the price to be even higher in the future. So one by-product of the fall in interest rates is that real house prices started to go up very quickly.
To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.

These imbalances have to be corrected. In principle, consumer spending can be brought down without the economy having to go through a recession, provided there is a sharp real depreciation of the US dollar, which would shift the structure of demand away from domestic spending and in favour of exports. On the other hand, the correction in house prices is likely to be contractionary. Some consumers have borrowed against the capital gains they made on their house, to purchase, for example, a second house or consumer durables. They are going to cut their consumption since they are more likely to become insolvent. As the collateral value of their houses falls, consumers will get less credit; hence a further drop in consumption. Furthermore, the securities backed by mortgages, subprime or otherwise, have been used as collateral by financial institutions; that collateral is worth less, thus reducing credit between those institutions. As a consequence, they will have more trouble lending to firms, so that investment will also be hit. The housing bubble has jeopardised the financial sector both because people have borrowed to hold it and because institutions have used the corresponding securities as collateral.

Because of this gloomy scenario, the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market. The signal sent by the Fed is that it is sound to join any market fad or bubble provided enough people do so, because one will be rescued by low interest rates once things turn sour. Worse, the more people join, the greater the lobby in favour of an eventual bail-out.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

High Oil Prices Will Save the World Economy?

Daniel Gros makes an interesting argument in the Financial Times today. Current high oil prices, he says, may just save the world economy from the intensifying credit squeeze. How so?

"The core of the issue is simple: oil producers tend to save about half of their windfall gains from higher oil prices. If the oil price stays around $90 a barrel, oil producers will increase their current account surpluses by $200bn-$300bn a year. The question will then be: who is willing and able to run corresponding deficits?"

In other words, the oil producing nations generate far more income than they spend and thus have excess savings. The excess savings will be lent out to (or used to buy assets from) countries willing to live beyond their means (i.e. run current account deficit). Since the world economy is being weighed down once again by tightening credit conditions that have emerged from the subprime mess, this injection of excess savings will provide the needed infusion of funding to keep the world economy going. Daniel Gros goes on to say,

"This prognosis implies, provided oil prices stay high, an ex ante savings surplus (in which surplus countries offer more savings than needed by deficit countries). That should lead to lower global real interest rates and/or higher asset prices – depending on the way petrodollars are recycled."

So excess savings from the oil exporters will keep real interest rates low and push asset prices back up. While I find this to be an interesting argument, I also find it confusing. Are we not in this current credit quagmire, in part, because of similar past excess savings from these same countries (and Asia) finding its way into the U.S. economy? (I say "in part" because I believe past U.S. monetary policy also played an important role) And why will there be more ex ante savings surplus this time around? If it is that oil prices are higher now, then why has there not been any impact already? I hope Daniel Gros is right and we soon see a lowering of spreads and easing of credit markets.

If, in fact, there will be more loanable funds coming to credit markets how will the underlying real economic distortions be worked out? Brad Sester provides one possibility in his posting "Should China buy Countrywide?": sell off U.S. assets, particularly troubled financial institutions invested in U.S. housing. He quotes Stephen Jen who says,

“We all know that SWFs [sovereign wealth funds] will have a very difficult time in the future, because of their vilified reputation. Buying cheap, strategic assets and appearing to be rescuing the US will carry immense long-term reputational benefits. More SWFs should jump in now, in my view. Countrywide would not be a bad choice. How much does it cost? Three weeks’ of reserve growth for China? Also, this may be the best time to buy US banks and financial institutions, as there would be the least political impediment to such inflows."

One implication, then, is that the excess savings will save the day as foreigners indirectly (or directly in some cases) buy up the excess U.S. housing inventory. This brings a whole new meaning to home ownership in America.

The Housing Boom-Bust Cycle as a Roller Coaster Ride

Here is a great video clip that portrays real U.S. housing prices as roller coaster ride. Unfortunately, the video clip only goes through the beginning of 2007 so the 'bust' part of the housing 'boom-bust' cycle is missing. Nonetheless, the video clip helps put perspective on the magnitude of the U.S. housing boom... fasten your seat belt.

A Deflation Article in Barron's

Barron's is running an article of mine this week titled "Deflation Isn't Always Dangerous." I make the case in the article that the failure of the Federal Reserve to distinguish between aggregate demand-driven and aggregate supply-driven deflationary pressures during the 2002-2003 deflation scare was a contributing (not sole) factor to the U.S. housing boom-bust cycle. The Fed read the deflationary pressures of this time as indicating weak aggregate demand; the evidence to me clearly points to rapid productivity gains being the source of the downward price pressure. In turn, this rapid productivity growth implied a higher neutral interest rate, but the Fed pushed its policy rate to historically low levels creating a Wicksellian-type disequilibrium.

For more details on this argument see these other related postings of mine: here, here, here, here, and here. If you read the Barron's article and are interested in the Postbellum deflation experience I briefly discussed in it, then check out my article titled "The Postbellum Deflation and Its Lessons for Today." I address some of the common critiques of this period's deflation in this article and show that this period's deflation was in fact largely benign.

Update

For some reason, the on-line version of my essay has several typos. So in case you do not have access to typo-free print version, here is how the on-line version should read as follows:

Deflation Isn't Always Dangerous
By DAVID BECKWORTH

IN 2003, AT THE HEIGHT OF THE deflation scare, Gary Stern was one of the few voices in the Federal Reserve System questioning whether the deflationary pressures of the time were truly a threat to macroeconomic stability. As president of Minneapolis Federal Reserve Bank, he was not convinced that the falling inflation rate was something to be feared. He viewed disinflation as a natural outcome of the economy's productivity gains. In his view, there was no need to cut the federal-funds rate to historically low levels.

Most officials in the Federal Reserve System, however, viewed the low inflation rate that time with alarm. They worried that it was the consequence of weakening demand in the economy. Their view prevailed and the federal-funds rate was cut to historically low levels. The inflation-adjusted, or real, federal-funds rate was pushed into negative territory and held there until 2005.

This move by the Federal Reserve appears to have been overly accommodative, and is now considered by many to be a key reason for the boom and bust in housing and related imbalances in financial markets.

Productivity was growing around 3% a year between 2002 and 2005, a rapid pace by historical standards. But today's conventional wisdom on deflation still is shaped by painful deflation experience of the Great Depression in the 1930s. Those who remember the past are afraid of repeating it.

Deflation -- an actual decline in prices -- can cause economic harm through several channels.

First, given relatively rigid input prices, such as wages, an unexpected deflation will lower firms' profit margins, reducing production and employment.

Second, unexpected deflation means debt becomes more onerous, leading to an increase in delinquencies and defaults, followed by weakening balance sheets of financial institutions and reduced lending.

Third, since actual interest rates reflect a real-interest-rate component and an expected-inflation component, deflation could pull short-term interest rates down to their lower bound of zero and prevent the central bank from being able to provide additional economic stimulus through cuts in interest rates.

Such events could reinforce each other in a deflationary spiral: Expectations of more deflation lead to a further fall in economic activity and push the economy into a prolonged economic slump.

This conventional wisdom, however, assumes deflation is always the result of a weakening in aggregate demand. It fails to consider that deflation may also arise from a boost to aggregate supply that is not accommodated by an easing of monetary policy. This benign form of deflation occurs as the result of productivity advances that lower per-unit costs of production and, in conjunction with competitive forces, put downward pressure on output prices. Here, profit margins are likely to remain stable even if input prices, such as wages, are relatively rigid, since the decline in a firm's sales price will be matched by the decline in its per-unit costs of production. Bank lending should not be adversely affected, either, since any unanticipated increase in the debt burden should be offset by a corresponding unanticipated increase in real income.

Productivity gains, which imply a faster growing economy, also typically imply a higher real interest rate to maintain economic stability, which in turn should prevent the actual interest rate from hitting the lower bound of zero.

Although rare today, this benign form of deflation emerged following the U.S. Civil War and persisted for almost 30 years while the economy experienced rapid economic growth and the U.S. became the leading industrial power of the world. Deflation in its benign form can be consistent with robust economic growth. Most Federal Reserve officials, however, simply failed to consider this possibility during the 2003 deflation scare.

The Fed missed the distinction and made the wrong call. It lowered real interest rates when productivity was growing. Its policy accelerated domestic spending when the economy was already being boosted by a series of positive aggregate supply shocks. The subsequent economic growth, therefore, had both a sustainable component -- the productivity gains -- and an unsustainable component -- the monetary stimulus.

Interestingly, the lowering of real interest rates and the subsequent credit boom all occurred without any alarming increases in the inflation rate -- the standard sign of overheating economy. This apparent stability, however, was illusory, since the inflation rate did indicate overheating relative to mild deflation rate that would have emerged from the productivity gains had there not been such a lax monetary policy in 2003.

The current problems in the U.S. economy are in part a failure of deflation orthodoxy. Federal Reserve officials, following conventional wisdom on deflation, misread the deflationary pressures in 2003 and fueled financial imbalances that today are just beginning to be worked out. Moving forward, it is important that the two forms deflation and their policy implications be better understood by monetary authorities. History can repeat itself, and sooner than we may now think.

Update II

The typos have been fixed in Barron's.

The Taylor Rule and Boom-Bust Cycles in Asset Prices

Lawrence Christiano, Roberto Motto, and Massimo Rostagno have a new NBER working paper titled "Two Reasons Why Money and Credit May be Useful in Monetary Policy." I find this article interesting because one of the reasons the authors cite for taking money and credit seriously in monetary policy--as opposed to standard New Keynesian analysis that sees little role for money--is that focusing "narrowly on inflation [alone] may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles in asset prices can be generated.

The authors explain that in "the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy."

In other words, these authors are arguing that by not allowing for benign deflation--deflation generated by productivity innovations--monetary authorities are generating too much liquidity and, in turn, fueling asset price boom-bust cycles. Does this sound familiar? I have been making this same point on this blog for some time, particularly with regards to the housing boom bust cycle of 2003-2005 (see here and here). Although it is refreshing it is to read prominent economists taking this idea seriously, I wish they would be a little more vocal about it. I would also point out that Borio and Lowe (2002) and Borio and Filardo (2004) made the same point several years ago. Also, do not forget George Selgin's important work on this issue.

Not a Pretty Sight

Menzie Chinn over at Econbrowser is feeling distressed today. He came across the below graph in the IMF's Global Financial Stability Report that shows the dollar amount of mortgage resets coming due in the future, as well as those in 2007. Take a look at the resets coming due in 2008--they are mostly subprime mortgages. Menzie looks at this sobering graph and concludes the "subprime resets in 2008 should put to rest the notion that the housing market's troubles are soon to be put behind."

House prices and the stance of monetary policy

A new paper provides further evidence on a view (see here, here, and here) promoted by this blog: past monetary profligacy contributed to the U.S. housing boom-bust cycle. Marek Jarociński and Frank Smets of the European Central Bank in a conference paper titled House Prices and the Stance of Monetary Policy find the following:

In this paper, we have examined the role of housing investment and house prices in US business cycles since the second half of the 1980s using an identified Bayesian VAR... There is also evidence that monetary policy has significant effects on residential investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002 to 2004 has contributed to the boom in the housing market in 2004 and 2005.

I wrote a similar note on U.S. monetary policy and the U.S. housing boom. In my note, though, I use a different measure of monetary policy than the paper above and discuss the issue from a more Wicksellian perspective. Nonetheless, the conclusions are essentially the same: the Fed was too accommodative during the "deflation scare" 2002-2003 and was slow to return to normalcy thereafter.

The Bubble Man Song

Via the Big Picture ,we have a great song from Scott Pettersen about the bubble man. Sit back, relax, and enjoy some great music.

How Bad Will It Get in the Housing Market?

Nouriel Roubini had a recent posting on his blog where he concluded he had been "Way Too Optimistic on the Housing Recession", this coming from someone known as one of the biggest bears on the housing market. He notes that his assessment of the housing market a few months, which many observers considered to be extreme, is now sounding very similar to the forecasts for the housing market coming from major investment banks on Wall Street. For example, Morgan Stanley is now calling for a cumulative decline in the number of housing starts to reach 56% while Goldman Sachs is saying housing prices will fall a further 15% on average before the dust settles sometime in 2008-2009. Robert Shiller is saying home prices will need to fall as much as 50% in some areas. So Nouriel was not too far off calling this the worst housing recession since the Great Depression.

The chief economist at Standard & Poors is now seconding this bleak outlook, as reported in the New York Post. (hat tip: NYC Housing Bubble). Some excerpts:

October 10,2007--A top economist predicted an even bleaker housing recession, saying it will last at least another two years, dragging down the American economy to trail the rest of the world. "Housing prices won't hit bottom until next summer and the losses won't peak for another two years, until 2009," said David Wyss, chief economist of Standard & Poor's. "We are not halfway through this crisis yet."

Although there has been an improved outlook for the economy overall, this housing sector analysis suggests we can look forward to deteriorating conditions in the housing market though 2009. Hang in there America.

Update

Sudeep Reddy at the WSJ Real Time Economics blog reports on a AEI panel discussion today on the outlook for the housing market and its influence upon the broader economy. Here is some of what Sudeep reports:

But the recent interest-rate cut by the Federal Reserve, and a rallying stock market, aren’t swaying some economists from their expectation of a housing-induced recession. It was more a question of when, not if, during a discussion today at the American Enterprise Institute about risks from the deflating mortgage and housing bubble.

"AEI visiting scholar John Makin said the recent performance of stocks suggests “financial markets are in a period of denial.” Housing downturns of today’s magnitude have always been followed by a recession, Mr. Makin says, calling the current environment a “textbook recession lead-up.”

“When you have a recession and the market doesn’t believe a recession [is coming], you get very radical changes in the financial markets,” he said. Credit instruments today “that are sort of hanging on by their fingernails…are not priced for a recession. I’m very concerned that we have a bit of a false dawn here, because that only delays the adjustment process.”

Desmond Lachman, a resident fellow at AEI, spelled out the key figures in case they’ve been forgotten: Previous housing booms featured a 20% inflation-adjusted appreciation in home prices. The current housing boom: an 80% increase in prices. House prices from 1979 to 2000 were 3.2 times people’s incomes; now they’re 4.5 times income. Mr. Lachman expects house prices to fall 15% to 30% from the peak to the ultimate trough. “This isn’t your regular kind of housing bust,” he said. “This is the worst housing bust that we’ve had in the post-war period.”

New York University economics professor Nouriel Roubini said housing starts would fall from the current annual rate of 1.3 million (a 12-year low) to 900,000 to clear the market glut, pushing down prices along the way. With a drop in business investment and consumer spending as well, that means a hard landing for the economy, he said. The stock market rallied in April and May of 2001 (just after a recession started) as the Fed eased interest rates. “The Fed cannot rescue neither the markets nor the economy,” he said."

Another Look at the Depressed Michigan Economy

In a previous posting I mentioned how the depressed economy in Michigan was making it difficult to sell my home. I posted a graph that showed how the Michigan housing market never benefited from the U.S. housing boom of 2003-2005, yet it is now feeling the pain of the U.S. housing bust. Poor, poor Michigan.

Over the past few days there has been added attention given to the depressed Michigan economy because of the Republican debate that was held there last night. For example, the New York Times reports on "Michigan's economic Woes" and the Arizona Republic reports "Michigan's plight backdrop of GOP debate on economy." Here is an excerpt from the latter article:

"We're an economic basket case, and it's dominating everything here," said Bill Ballenger, editor and publisher of the influential nonpartisan newsletter Inside Michigan Politics. "Our unemployment rate is 7.4 percent, the highest in the country. We've lost 400,000 manufacturing jobs, which is the heart of our economy here in Michigan. We've just never really recovered from the 2001 recession, and that has affected state revenues and has led to a budget crisis here that has been largely averted now, but there are still a lot of problems. Michigan is the worst, probably, in the entire country."

I find it interesting that Bill Ballenger says the Michigan economy never really recovered from the 2001 recession. This lack of recovery is evident in the my housing graph from this previous posting. Following its report on the debate last night, NPR also chimed in on the depressed Michigan economy with this discussion. By far, however, the most interesting piece I saw on the Michigan economy is the video clip below from CNBC. Among other things, it discusses how the foreclosure rate in Michigan is one of the highest in the nation and how home prices in Detroit have fallen 32% over the past year. (Thanks to Brian Arner for helping me make the video clip work.)

CNBC's Diana Olick reports on the Michigan housing market.

Update:

Paul asks about the housing market in Ann Arbor in the comments sections. I turned to the OFHEO housing price index for insight. Here is a figure constructed from the OFHEO index that shows the year-on-year housing price growth rate in current dollar terms.

The Housing Recession Hits Home

Readers of my blog know I have taken a hard line against Fed interventions during the past few months. For example, in "Sound Policy or Liquidity Addicts" I took the Jim Cramer's of the world to task for their calls for a Fed bailout of financial markets. Some readers may read postings like that and conclude that I am just another out-of-touch academic spouting painful policy prescriptions from the comfort and safety of my ivory tower. If this thought has crossed your mind then this posting is especially for you.

Yes, I have been prescribing painful economic medicine, but this advice has not been in my own self-interest. This past summer I moved from Southwestern Michigan to Central Texas. As part of this move, I put my home on the worst national housing market in the past 40 years. What made my life even more interesting is that my house was placed on one of the worst state housing markets as well. Consequently, my home has been getting few bites and I have been making two home payments. Two home payments for our one-income family have been painful. Questions about this arrangement persisting for some time--some observers are predicting the housing recession will continue through 2009--has also been troubling. To add some perspective to this discussion consider the two figures below. These figures show the growth rates of the OFHEO housing price index for the nation, the state of Michigan, and South Bend, Indiana. The latter one is included because my home was not too far from South Bend, Indiana. The first figure shows the growth rates of housing prices unadjusted for inflation:

This figure shows the Michigan housing has had some big swings in the past and currently is declining in current dollar terms. Moreover, the figure indicates that Michigan and South Bend housing markets never really were part of the housing boom during the 2003-2005 period. The bottom line from this figure is that I bought a home in a particularly weak housing market... not very promising. But wait, there is more to this story. The above figure does not adjust for inflation. What has been the real return for houses in Michigan over this time? The next figure, which takes the OFHEO index and deflates it with the PCE deflator, answers this question:

This figure is striking: the growth rate of real home prices in Michigan has been declining since 2001 and turned negative in 2005. The South Bend, Indiana housing market is slightly better than the Michigan housing market, but still is relatively flat compared to the national average. Some caution should be taken in evaluating this figure: the regional housing price indices were deflated with a national price index. I am not sure, though, that the outcome would be much different if a regional price index were used.

Now back to my world. This week my wife and I finally received an offer on our home. We gave a counter offer and the prospective buyers accepted. Our counter offer requires us to bring money to table. We are glad to be paying this amount just to unload our home. So, we too have been hit by this housing recession. I would like to think that makes me an academic who has not lost touch with the real world

Update
I redid the second figure with the PCE deflator. The results seem more reasonable than what they were using the CPI as the deflator.

George Selgin and Monetary Policy Today

Here is an article by George Selgin from August 31 that takes a similar view to mine (see here and here) on the role U.S. monetary policy has played in the housing boom-bust cycle that now plagues the U.S. economy. (This is the same George Selgin to whom I referenced in an earlier posting about the Productivity Norm rule for monetary policy.)

Federal Reserve should resist tinkering
"When the Federal Reserve slashed its discount rate by a half-percentage point earlier this month, it was trying to add a little lubricant to a credit market that seemed on the verge of seizing up. But by giving weary investors a chance to catch their breath, the move also gave them an opportunity for finger pointing – at avaricious mortgage lenders, at naive borrowers, and at rating agencies.

One culprit, though, has not only avoided blame but has come across as the episode's hero. And that culprit is the Federal Reserve itself. Like some renegade fireman, though unwittingly, the Fed played a part in igniting the conflagration it's now trying to smother.

Because the disaster was kindled years ago, responsibility for it belongs not to the current Fed board but to Alan Greenspan and his team of monetary policymakers. The fundamental problem, however, transcends the actions of any Fed chairman. Indeed, the Fed as it's presently managed can hardly help causing sometimes ruinous market distortions.

Why did mortgage lenders earlier this decade start showering credit as if it were spewing from a public fountain? The answer is that credit was spewing from a public fountain – and that fountain was the Fed. In December 2000, the Fed began an unprecedented year-long series of rate cuts, reducing the federal funds rate from over 6 percent to just 1-3/4 percent – a level last seen in the 1950s. By mid-2003, two further cuts had reduced the rate to just 1 percent.

The general aim of these cuts was to keep a mild growth slowdown from getting worse. But they had the quite unintended effect of generating euphoria in the mortgage market by flooding it with funds. Lenders dramatically lowered mortgage rates and kissed old-fashioned lending standards goodbye. Buying property was never easier. As one jubilant industry insider put it, "Who could ask for anything more?"

The sad sequel is grist for the mill of monetary economists long critical of central banks' attempts at fine-tuning. It illustrates the late Milton Friedman's claim that the full effects of monetary policy changes happen only after "long and variable lags," when conditions that motivated the changes have passed into history. The result is that fine-tuning often ends up promoting business cycles instead of dampening them.

The subprime lending crisis also shows that, while central banks certainly have the power to expand a nation's spending power, they can't guarantee that the extra power gets used as intended, namely, to give a roughly uniform boost to the overall demand for goods. On the contrary: The crisis supports the argument, first developed by Austrian-school economists Ludwig von Mises and Friedrich Hayek, that the techniques central banks employ to increase spending power are bound to distort spending patterns by driving lending rates below their sustainable, "natural" levels.

By injecting the new money they create into credit markets, central banks create an artificially high demand for long-term investments, such as real estate, in which interest costs loom large. Think back a few years. Even your auto mechanic was bragging about "flipping" condos with easy credit. That's a natural consequence of the way central banks distort spending patterns. The trouble, however, is that the new money does eventually swell overall demand, including the demand for credit. Interest rates soon rise, ending the investment boom. Regrets multiply.
That's exactly what happened last year, when the federal funds rate climbed back above 5 percent.

In hindsight, it's easy to say that the Fed blundered. But avoiding similar blunders in the future is another matter. The truth is that the Fed, as presently constituted, faces an impossible task: It can't tell whether its targeted rates are "natural" (and therefore sustainable) except in retrospect, when it's too late; and it will always be tempted to engage in fine-tuning, both because the Humphrey-Hawkins Act of 1978 calls for it to do so, and because a myopic and inadequately informed public rewards Fed bureaucrats for "doing something" even when they ought to stand pat.

Only institutional reform can get us out of this predicament. The Fed must be taken out of the fine-tuning business. Instead, it must observe a strict and unambiguous monetary rule, such as one calling for the Fed to announce and stick to an inflation-rate target. As it happens, chairman Ben Bernanke favors such a rule. If Congress gives him what he wants, the Fed may be spared some future finger pointing; and the public may be spared further crises."

• George Selgin is a professor of economics at the University of Georgia's Terry College of Business.