Are We Entering the Third Mode?

Remember Brad DeLong's cure for the third mode?:

The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger. Easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system... It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system's capacity to guide resource allocation. But even this is almost surely better than a depression. ...

At the start, the Fed assumed that it was facing a first-mode crisis -- a mere liquidity crisis -- and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis -- more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.

As Fed Vice Chair Don Kohn recently put it: "We should not hold the economy hostage to teach a small segment of the population a lesson."

No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.

John Makin says it's time:

The Inflation Solution to the Housing Mess, by John H. Makin, Commentary, WSJ: The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the Federal Reserve 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-Shiller Home Price Index – it's almost certain that Washington will end up nationalizing the mortgage business.

So far, the Fed's lending programs have not provided adequate liquidity to financial markets...

Congress and the Treasury have proposed voluntary measures to help mortgage borrowers, but the impact on mortgage availability has been nil. ... Overall access to credit is contracting...

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 bottom line is this: The Fed could have watched a run on investment banks quickly turn into a run on commercial banks, or protected the creditors of investment banks (like the depositors of commercial banks) at the expense of Bear Stearns' shareholders. The Fed wisely chose the second alternative.

Still, the Fed's intervention has done no more than buy a respite from the crisis... 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 desirable 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. But the alternative is to struggle with a patchwork of inadequate efforts to shore up mortgage markets, while the Fed sticks to its current tactic of pegging the fed funds rate without increasing the money supply. This, I would submit, is even more risky. It risks a severe recession that will only intensify the drive for reregulation of financial and mortgage markets after the election. ...

While there is no guarantee, direct injection of money holds some promise of alleviating the worst of the credit crisis. This means that, after the election, Congress will not feel justified in nationalizing mortgage markets.

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 nationalization of the mortgage market. ...

I don't think we are there yet.

Comments

[Winslow R.]

We've heard Volcker and Greenspan. I wonder what Arthur Burns would say right about now?

http://en.wikipedia.org/wiki/Arthur_F._Burns

[esb]

Arthus Burns would say that he never met a devalued dollar that he didn't like.

(Richard Milhous Nixon once said that nobody ever lost an election because of inflation.)

This joker Makin is over at AEI (the American Enterprise Institute), the neocon think tank that gave us the Iraq war, wants an Iran war, and embraces the PNAC doctrine.

I wouldn't trust him to put a quarter into a gumball machine.

[SanFranciscoJim]

I thought the AEI was a Conservative institution that believed in things like personal and fiscal responsibility. I guess anything is better than being watching the financial industry re-regulated by a Democratic Congress and White House.

[Patrick Fitzsimmons]

This makes me sick. The people of my generation ( I'm 24 ) are looking at home prices that are 4X median income. My dad paid half down for our house. I can't imagine doing something like that, and neither can anyone else in my generation. We need to let home prices come down, not have money taken away from people who saved responsibly and given to those who borrowed irresponsibly.

[Jim]

Housing costs have to fall to a level where the historical proportion of home ownership can be sustained. Home buyers for the foreseeable future will have to put 20% down, have documented employment, and a good credit history. Some moderation of the bursting bubble by the Feds makes sense, but ultimately this is a market issue. Prices will settle when prudent and able buyers find that owning makes more financial sense than renting. Homes will not be hot investments, just a place to live at a fixed price.

[esb]

SanFranciscoJim:

Actually, what Makin (and the AEI) wants is to use inflation to finance the war(s).

End the Iraq war, don't start an Iran war, prevent Israel from starting an Iran war and just skip the inflation financing.

With the war burdens lifted we have a reasonable shot at being made whole once more, both financially and morally.

(It is the morally part that is most important.)

[Winslow R.]

I've been following Makin for years and his predictions are almost always right on target.

Given he is willing to post his past articles in a easily accessible format, verification is easy for those who have any doubts.

http://www.aei.org/scholars/filter.all,scholarID.40,type.1/pub_list.asp

[dissent]

How utterly bizarre.

One issue with inflation: there's no power in labor anymore, and a price spiral would not necessarily take wages up with it.

[SanFranciscoJim]

Yeah, the whole point is to legally semi-default on a bunch of foreign bond holders.

[a]

And how pray tell can one be sure that inflation doesn't turn into hyperinflation? DeLong says inflation is better than depression. Maybe. But depression is better than hyperinflation followed by depression.

[Farrar]

Makin's inflation solution is an obvious recipe for disaster, but that seems to be where we are headed. This is a reaction to be expected from AEI after G7MinFin admonitions to banks to get their houses in order.

If investment and commercial banks are not able to meet the G7 deadline, then we are obviously in phase 3,and nationalization remains the only rational solution. As we know, however, the Bush admin is not rational.

[ken melvin]

So much for markets, huh? Someday, we'll have to tear up the rat nest and start anew.

[Quality]

After WWII, safe/clean homes sold for about 6k (60k in inflation adjusted dollars). A man could get a job, and comfortably support his wife and children on the wages from that job alone. Today, both parents work full time, and are forced to work overtime on top of it, just to pay fantastic prices. Prices today are ridiculous, and not just for homes. This constant inflation stuff has sneakily eroded the quality of life for the median citizen. Its time to put a stop to it.

End inflation now. Its just a big trick to take things away from hard working people, and give those things to borrowers. A stable dollar allows those who work to keep all that they earn, even if they defer some consumption for their old age.

Catering to people who want to borrow, and not pay back, is destroying the quality of life. Enough of allowing borrowers to pay back with inflated dollars. Pay back all that you borrow so the rest of us can have a decent life without endless overtime.

[Farrar]

PARDON MY CAPITALS, BUT I GUESS I HAVE TO SHOUT TO MAKE MYSELf HEARD IN THIS DEBATE. ISN'T IT STRANGE THAT N OONE HAS PAID ANY ATTENTION TO BRAD DELONG'S FIRST OPTION IN THE THIRD MODE ?

"First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system... It is merely the best organization available."

Inferentially, this is Delong's preferred option, since he placed it first. Also, most of you commenters reject the second option, Makin's inflation to save Wall St.

In case of tipping into the third mode, nationalization of the weakest elements in the banking system could rehabilitate credit and finance. Alls you do is replace blood sucking top management, with trained treasury types, and continue with mid level management, with is the life blood of the system in any case. This also has the advantage of lessening moral hazard.

There is no assurance, however, that this would resolve the housing crisis. Why not create a govt corporation, overseen by HUD, which would take over distressed housing, and either rent units directly to occupants, or turn them over to subsidized REIT's which would convert such housing into HUD housing units, which are all too scarce in many parts of the country? As one regular commenter, suggested a while back, McMansions could be converted into duplexes or even quadplexes, thereby bringing a more desirable mix to many residential neighborhoods, and more work for building companies.

This would also give legislators an opportunity to send profit making opporunities to some of their favored constituents. Historically, a little graft has always helped grease the wheels of commerce and recovery.

[hari]

If you guys want to get a more seasoned professional view on the current policy imperatives try *Dr Doom* (Henry Kaufman)
interview by FT.

[hari]

If you guys want to get a more seasoned professional view on the current policy imperatives try *Dr Doom* (Henry Kaufman)
interview by FT - seee Links today.

[ndd]

Farrar,

FWIW I agree with you. If it is true that the current financial players are insolvent, the US can step in a la the Chrysler bailout, take a huge equity stake in some players, recapitalise them, and regulate them to make sure they don't get into the same trouble as current players.

At the appropriate time, the US on behalf of its taxpayers, can start cashing in its chips.

[Quality]

"..simply nationalize the broken financial system..."

Sure, go ahead. The justification for keeping the system in private hands is the supposed better management. However, the failed business models employed by some institutions should not be perpetuated. Get rid of them. Let someone else start a new firm with a better business model.

[slumber]

Nationalisation, and regulation, of the financial system seems like a step in the right direction. Inflation seems like a step (or two) backwards, a risky and painful strategy that will cripple a generation. Whatever solution is followed, hopefully it will involve looking towards the long term. The complete lack of perspective in the buildup towards the crises (plural), and the current handling of the crises, scream of knee-jerk reactions. Anything to survive another month.

There's no shortage of creative solutions proposed, and no doubt many of them could ameliorate the curruent and future conditions. But elected 'leaders' need to actually *lead*, make considerate decisions and not simply react according to their ideology.

[CathyG]

I can't tell whether Makin is dishonest or merely disingenuous. What part of Main Street's pain would be softened by a rate of inflation sufficient to mitigate a 30% drop in house prices? This would be devastating to anybody on a fixed income, any worker with little wage negotiating power (far too many of us today), virtuous savers, and anyone planning to retire shortly (aka Boomers).

Perhaps the most repugnant aspect of his proposal is the effect this will have on poorer people around the world. We're exporting our inflation right now. Food price inflation which forces Americans to use coupons, seek out sales, eat less meat and shop at discount grocers, causes people in the poorest nations to starve.

If this is the best that American economists can come up with, then the whole useless lot of you ought to resign your chairs in disgrace and get honest jobs. At soon-to-be- opening soup kitchens, perhaps.

[Slovokia]

Patrick Fitzsimmons says "This makes me sick."

I completely agree. What I find interesting is how so many economists of the leftish persuasion think it is so grand to use inflation to redistribute wealth from unsophisticated, responsible savers to various intermediaries like banks, hedge funds, and the sophisticated who invest with other peoples money. All in the name of "saving the economy".

What a complete crock. All I can say is I hope foreigners stop lending to the U.S. soon (at least in dollars). Better yet I hope a major US financial institution makes it very easy to open bank accounts in foreign currencies. Savers need to get some revenge for 5+ years of interest rates below the CPI.

[esb]

Slovokia:

Everbank has some interesting products, but it is a bit player.

Also, before going over 100K in deposits at Everbank, one would be wise to look over the related FDIC data on the institution.

I'll leave it at that.

[steve]

No need to panic. Lower all our tax brackets by 3% and give a 10-15k tax credit to anyone that buys a home in the next 24 months. Lowering rates doesnt help at this point, too large a percentage of the population is at the 80% ltv ratio anyway....because each year they run behind and have refiniance to catch up........the only solution is to let us keep mre of what we make.....dont worry, if they let us keep more....we will spend it.....