Feldstein: Problems Run Deeper than Wall Street

Martin Feldstein seems discouraged about the prospects for the economy, and he has little confidence in the ability of monetary or fiscal policy to do anything about it:

America's Problems Run Deeper than Wall Street by Martin Feldstein: ...We are in the midst of a financial crisis caused by the serious mispricing of all kinds of risks and by the collapse of the housing bubble... What started as a problem with sub-prime mortgages has now spread to houses more generally, as well as to other asset classes. The housing problem is contributing to the financial crisis, which in turn is reducing the supply of credit needed to sustain economic activity.

Indeed, the financial crisis has worsened in recent weeks... Ultimately, these financial failures reflect the downward spiral of house prices and the increasing number of homes with negative equity, i.e., with substantial mortgage debt in excess of market values. ...

We cannot be sure about how much further house prices will fall. Experts say another 15% decline is required just to return to the pre-bubble price path. But there is nothing to stop the decline from continuing once it reaches that point. ...

As homeowners with large negative equity default, the foreclosed homes contribute to the excess supply that drives prices down further. And the lower prices lead to more negative equity and therefore to more defaults and foreclosures. It is not clear what will stop this self-reinforcing process.

Declining house prices are key to the financial crisis and the outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions. Until house prices stabilize, these securities cannot be valued with any confidence. And that means that the financial institutions that own them cannot have confidence in the liquidity or solvency of potential counterparties – or even in the value of their own capital. Without this confidence, credit will not flow and economic activity will be constrained.

Moreover, because financial institutions’ assets were bought mainly with borrowed money, the shortage of credit is exacerbated by their need to deleverage. Since raising capital is difficult and costly, they deleverage by lending less.

But the macroeconomic weakness in the US now goes beyond the decreased supply of credit. Falling house prices reduce household wealth and therefore consumer spending. Falling employment lowers wage and salary incomes. The higher prices of food and energy depress real incomes further. And declining economic activity in the rest of the world is lowering demand for US exports.

The US Federal Reserve has, in my judgment, responded appropriately..., but ... monetary policy appears to have lost traction...

The US Congress and the Bush administration enacted a $100 billion tax rebate in an attempt to stimulate consumer spending. Those of us who supported this policy generally knew that history and economic theory implied that such one-time fiscal transfers have little effect, but we thought that this time might be different. ...

In the end, our hopes were frustrated. The official national income accounting data for the second quarter are now available, and they show that the rebates did very little to stimulate spending. More than 80% of the rebate dollars were saved or used to pay down debt. Very little was added to current spending.

So that is where the US is now: in the middle of a financial crisis, with the economy sliding into recession, monetary policy already at maximum easing, and fiscal transfers impotent. That is an unenviable situation, to say the least, for any incoming president.

That is why I continue to argue that government spending is better than tax cuts, especially temporary or one time tax cuts (see the 1975 and 2001 tax rebates), if the goal is to stimulate the economy:

I prefer government spending to tax cuts as a means of stimulating the economy since the effect on aggregate demand is more certain, and spending can be directed toward particular, high employment, high economic return projects such as rebuilding infrastructure and addressing environmental concerns

With tax cuts and rebates, you create an incentive and hope people act on it in a way that stimulates GDP and employment. But there's nothing to guarantee that people will spend the money on goods and services and increase aggregate demand. Instead, they may pay off debts or save the money. With government spending, there is no such uncertainty since government purchases of goods and services impacts aggregate demand directly. In addition, a well designed policy can provide simulus to the economy in the short-run and also address critical infrastructure and other needs that will allow the economy to grow faster in the future.

Comments

[James Kroeger]

Amen, Mark...preach it, brother...

The one thing I'm not hearing from you, Mark, is a reassurring explanation that even if the supply AND the demand for loanable funds were to drop 'alarmingly', it is still well within Congress' power to return the economy to prosperity if it were to (A) SPEND enough, and (B) make available abundant loanable funds, through a bank of its own creation, if necessary.

Seriously, Mark...if Congress were to spend $1 - $1.5 trillion on infrastructure outlays AND it were to create a taxpayers' bank that lent freely to small businesses, non-financial corporations, and households (mortgage refinancing, big ticket purchases), wouldn't you agree that such a stimulus would create an economic boom on Main St., even while the banking sector is seizing up?

What precisely would be your objection to Congress taking such dramatic action, under the circumstances?

[Oupoot]

Outside the box solution: give the $700bn in the form of tax rebates to households. 80% of the previous $100bn rebate was spend by hhlds on debt reduction, so there is a very good chance that a similar scenario will hold true, i.e. 80% of the $700bn ($560bn) will be spent to reduce private hhld debt. As this is spend on the debt with banks, it is in effect a $560bn cash injection into the financial system, but at the same time reducing the debt burden of households. This will also reduce the default risk of hhlds significantly, vastly improving the quality MBS debt held by fin institutions.

Trying to ensure that this goes to the most distressed hhlds for equity's sake could make it a nightmare to administer. I suggest a simple approach, as used previously, be adopted.

It is a direct transfer of private debt to public debt, but as many economists have pointed out, though very big, public debt in the US is still quite manageable. To pay for it, simply increase future taxes on the rich who benefitted most from the financial sector bubble (i.e. just let the Bush tax cuts expire).

[James Kroeger]

Amen, Mark...preach it, brother...

The one thing I'm not hearing from you, Mark, is a reassurring explanation that even if the supply AND the demand for loanable funds were to drop 'alarmingly', it is still well within Congress' power to return the economy to prosperity if it were to (A) SPEND enough, and (B) make available abundant loanable funds, through a bank of its own creation, if necessary.

Seriously, Mark...if Congress were to spend $1 - $1.5 trillion on infrastructure outlays AND it were to create a taxpayers' bank that lent freely to small businesses, non-financial corporations, and households (mortgage refinancing, big ticket purchases), wouldn't you agree that such a stimulus would create an economic boom on Main St., even while the banking sector is seizing up?

What precisely would be your objection to Congress taking such dramatic action, under the circumstances?

[Gegner]

I don't wanna go poking pins in anyone's balloon here but where, pray tell, is our government going to cough up 1 to 1.5 trillion dollars?

If printing money were the answer, Zimbabwe would be the most prosperous nation on the planet.

Worse, this administration has already doubled the national debt (outspending every previous administration, combined) and we have absolutely zero to show for it!

How do you suppose 'more of the same' will help?

This bad boy is broke and the only way to fix it is to hit the 'reset button'...and I ain't too keen on doing that with the current bunch still in charge.

[Ranjit Mathoda]

Warren Buffett says giving the Treasury Secretary the resources and flexibility to create liquidity is the right first step: http://mathoda.com/archives/433

[James Kroeger]

I don't wanna go poking pins in anyone's balloon here but where, pray tell, is our government going to cough up 1 to 1.5 trillion dollars? If printing money were the answer, Zimbabwe would be the most prosperous nation on the planet.Contrary to what you've been led to believe, the Fed can destroy money just as easily as it can create it. Here's how it goes:

When there are not enough loanable funds in the hands of bankers, the Fed simply buys securities from commercial banks with money that it creates out of thin air with a keystroke. This puts loanable reserves into banks that were not saved by any saver.

If the economy were booming, and inflation were creeping up, this addition of money to they system would indeed be inflationary, as you suggest. But if banks are not lending money for any reason, the the injection of new money into the system is NOT inflationary.

It is only when the banks begin to lend again that inflationary pressures would begin to build. But that's when the Fed is free to remove money from the economy by selling the securities it has. Buyers pay for the paper with cash, which is then effectively removed from the economy.

So much for inflation.

Note that hyperinflation only occurs in countries that desire to see it happen. Any govenment that does not want to see hyperinflation happen, will not see it happen.

To answer your question...here, pray tell, is our government going to cough up 1 to 1.5 trillion dollars?the government can obtain the money by increasing the tax rates of the wealthy. Whenever the economy starts to contract, there are excess savings in the economy. If Congress taxes the richest of the rich with steeply progressive income taxes, those dollars (that would have been removed from the economy by rich savers) are returned to the economy in the form of government spending.

[hari]

I agree gov spending is better, if properly tragetted, than tax cuts.

This is where Scandinavian economic model comes into play principally because the state regards itself as an active player in the delivery and execution of financial and economic policy.

EU govs have also displayed, in recent years, a tendency to follow their northern neighbours particulary in the area of education and science and technology.

The role of the state in delivering economic and financial regulatory framework is well developed in most EU countries today, however after subprime fraud and pricing/marketing of CDS, all govs will now have to return to the table and discuss the way forward...transparency in financial markets.

Decades of unregulated financial markets and their instruments will not be easy to undo overnight; but the process has started last nights Senate debate and a lot more is expected in 2009.

[ken melvin]

"... caused by the serious mispricing of all kinds of risks and by the collapse of the housing bubble...

And what pray tell led to this housing bubble that collapsed? Is the falling prices and somehow not their rise?

"But there's nothing to guarantee that people will spend the money on goods and services and increase aggregate demand.

The problem with the goods and services argument is that the goods are made overseas and wages for services have been forced down by the employment of low wage illegal immigrants.

[Robinia]

With tax cuts and rebates, you create an incentive and hope people act on it in a way that stimulates GDP and employment. But there's nothing to guarantee that people will spend the money on goods and services and increase aggregate demand. Instead, they may pay off debts or save the money.

Absolutely agree-- this is also what is wrong with the "war between the states" approach to state and local economic development, predicated on tax abatements. What often remains unsaid, but is of crucial importance, is that tax cuts, rebates and abatements, especially when given to high-income individuals and businesses are often spent outside the national economy. Offshoring production, recreational and business travel internationally, and direct importing of goods and services (often using computer-aided commerce) are serious leaks in any system of national economic stimulus that pumps funds into the economy through not collecting taxes otherwise due. If we want to stimulate the US economy, we ought to at least be certain that the funds expended are used in the US economy.

[markg]

I sometimes don't know what economist want. They complain Americans spend too much, have too much debt, and save too little. But when Americans are given a temporary tax cut (the rebate is nothing more than the govt saying "oops, we taxed you too much, here is some back") economist complain that Americans didn't spend it, they paid down debt or saved it. I say the govt should give a permanent tax cut (the payroll tax since it hits the working class the hardest) until Americans are satisfied with savings and comfortable with debt levels and then start spending. In the mean time, I do agree with Mark that some govt spending on much needed infrastucture (including energy) would get the ball rolling. As for the govt debt levels or Social Security Trust Fund, well economist also need to understand and teach to the public a fiat money system with floating exchange rates.

[bakho]

I totally agree with Mark. However, it runs totally counter to Republican ideology and is impossible to enact with a Republican president. 2 or 3 times an hour in Indiana, the RNC is running anti-Obama ads that attempt to portray Obama as a big spender. There is not only a political battle that needs to be won, there is an inane Republican ideology that needs to be totally discredited before we can have intelligent political conversations.

I would prefer that Obama drop his middle class tax cut in favor of spending on jobs. Especially in a recession, job creation is much more important than cutting taxes.

[bakho]

Yes, the problems run much deeper and arise from a massive misallocation of resources into housing that is neither affordable nor sustainable and is not the type of investment that, once in place, generates a lot of returns or job creation. Throwing good money after bad does not help. The good money needs to flow to good investments that create jobs and deliver energy alternatives and efficiency to get commodity prices under control.

[Andrew]

I realize it is cliche to say "Oh, that's Econ 101," but this is literally Econ 101. I just went and looked it up in my old textbook.

The magnitude of the government expenditure multiplier is greater than the tax multiplier on aggregate demand.

[anne]

"Declining house prices are key to the financial crisis and the outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions. Until house prices stabilize, these securities cannot be valued with any confidence."

That was the argument of (shudder) Jesse Jackson several years ago, watching closely what was happening in African American and Latino neighborhoods as excessive cost mortgage problems mounted. Hillary Clinton in turn suggested working directly on household problems to limit the slowly but surely developing mortgage crisis, but Clinton was ignored or ridiculed for the proposal and the Democratic leadership, which would not understand at the time, has still not come to understand.

Where were the economic advisers of the Democratic presidential candidate all these months? After all, the Democrats were supposed to be fashioning opposition responses to policy from the current Administation let alone the minority in Congress.

[Real Person from the Real World]

A sales guy I know at our company claims that the US Gold Reserves are the biggest in the world, and if things got too bad, they could let some of it go, and that would get things back to normal. I am not sure about this, and would assume what is gone is gone, and once gone, what if it did not work. Any comments or is this too insane an idea?

[anne]

Jesse Jackson understood as early as Paul Krugman, because Jackson cared about troubled households and neighborhoods. Who listened politically beyond the emerging Presidential candidates Clinton and the forgotten Edwards and always ignored Kucinich?

[Progressive]

"I prefer government spending to tax cuts as a means of stimulating the economy..."

As long as the spending is ultimately funded (even if temporarily borrowed from overseas) via a progressive income tax, and not the accursed regressive inflation tax.

[Andrew]

Real Person from the Real World,

"The United States' holding of gold is worth approximately $241 billion (July 2008)."

There is not enough gold in the world to back the amount of debt out there right now.

[Lafayette]

JK: When there are not enough loanable funds in the hands of bankers, the Fed simply buys securities from commercial banks with money that it creates out of thin air with a keystroke.

OK, but not without consequence. What you end up with is ... here.

The Paulson Plan of $700B will represent 5% of the present GDP at $13.9T. We are a country that can afford it, even if it is consequence of extreme stupidity on the part of Investment Bankers chasing a pot of gold.

We've spent more in that war over in the sandbox without raising such a ruckus, remember. That war was a more justified expenditure than the subprime mess?

[Julio]

From the article:

"As homeowners with large negative equity default, the foreclosed homes contribute to the excess supply that drives prices down further. And the lower prices lead to more negative equity and therefore to more defaults and foreclosures. It is not clear what will stop this self-reinforcing process.

Declining house prices are key to the financial crisis and the outlook for the economy, because mortgage-backed securities, and the derivatives based on them, are the primary assets that are weakening financial institutions."

So, how about addressing the problem?

Instead of perpetually tinkering with the world of financial paper built on top of it.

Such as: Managing to commit $700 billion without guaranteeing that a SINGLE foreclosure will be avoided.

I'll take the Kroger Plan over the Paulson Plan anytime.

[VG]

The government should commit to buying ten million electric cars from American manufacturers over the next five years. Give them away to low income people.

In one stroke you get a more employment and industrial activity, decreased oil imports and a more employable workforce.

Also, people like cars.

[Julio]

Anne:

"Jesse Jackson understood as early as Paul Krugman, because Jackson cared about troubled households and neighborhoods. Who listened politically beyond the emerging Presidential candidates Clinton and the forgotten Edwards and always ignored Kucinich?"

Anne, did you mean to post this in theotheramerica blog?

[don]

Hard to argue with Marty here. He seems to have gotten the faith, like when he told Reagan his policies would lead to massive deficits. One thing he omits, though, is the current account leakage. The part that comes from Asian currency mercantilism needs really to be addressed. Smoot-Hawley taught everyone a lesson, but we simply can't let current trends continue.

[Lafayette]

Article: Experts say another 15% decline is required just to return to the pre-bubble price path.

Journalistic license, this one.

The pre-subprime mess is when? If we consider this chart, here, it is pre-1995. If we consider this information here, prices have to decline another 50%. That is not going to happen.

Obviously, we have not yet defined exactly when the sub-prime mess started. I figure it is, indeed, in 1995. What I'd like to know is when an Investment Banker "financial engineer" thought up the idea of structuring toxic waste into an SIV and monetizing the debt.

[Jeff]

Martin Feldstein may not know it, but there is a lower bound for house prices: when the mortgage payment on a 20% down mortgage is 20% less than the what the house can rent for, investors can buy the house and rent it out with a positive cash flow equal to what they'd earn if the down payment were invested elsewhere. There may be some small amount of overshooting below this price, but not much, as this is really a one-sided arbitrage condition.

[acerimusdux]

Neither monetary or fiscal policy has been tried yet.

Mark is correct that we need government spending as a fiscal stimulus.

But on the monetary side, we also need stimulus, by using new currency to buy up debt. This big $700 billion plan will only worsen the credit crunch, precisely because they apparently intend to pay for it with $700 billion in new treasury debt.

Hello?

There is a squeeze on business borrowing precisely because all of the money fleeing into safe short term Treasuries. Instead of driving those short term rates still lower and really tempting people into more lucrative business lending, we are now going to soak up an additional $700 billion of that short term capital into Treasuries?

And, instad of the proceeds going to provide credit in those captial markets where is is needed, it is going to throwing more money into the mortgage sector?

Do they not realize this will make the contraction worse?

[Lafayette]

Battle Cry

Jeff: ... when the mortgage payment on a 20% down mortgage is 20% less than the what the house can rent for, investors can buy the house and rent it out with a positive cash flow equal to what they'd earn if the down payment were invested elsewhere.

Interesting comment.

The rental value of property, here in France, is typically 5% of its retail value. A house/apartment selling for 100,000 euros will rent at 5000 euros per annum. Five percent is close presently to the nominal rate of interest.

But, should interest rates here drop, which they may well do in the near future, rents will not. Because there is a shortage of rental properties. So, once again, market factors will determine how far both property and rental values will fall.

Are you therefore sure that the mechanism cited above would function in reality? Most rentals, in my experience, are made to cover purchase financing costs (mortgage, credit), the buyer relying on property value appreciation solely for long-term profit.

And, this was the idiocy of the subprime mess. People were told and made to believe that hallucinatory property value appreciations would continue long enough for them to recover a sizeable profit in a relative short period of time.

Which is the Battle Cry of the "I want it all and I want it now!" generation.

[K Ackermann]

The whole thing stinks like rotten meat. I have real reasons for thinking the bailout is the wrong thing, but first I want to tell you what I think goes past all decency:

That I may get turned down if I try to borrow my own money. Even worse, if I get approved, I will have to pay interest to borrow my money. I have already tried to call the cops, but they won't do anything. I am going to steal a bank executive's car, and if he or she wants a ride bad enough, then they can pay me to drive them around.

There are so many moral hazards they are establishing, it's like giving a drunk a set of keys to the liquor store. For instance, banks will be allowed to issue debt that is backed by the FDIC. That would make them zero-risk bonds. What's the coupon, 10%? I can be better than Buffet.

Anyway, if the Fed and the Treasury would just play the game of Capitalism and quit trying to prevent mark-to-market, we could be working through this right now and be certain of the outcome. There is a price for that paper, and they should let the banks find it. The government has magic powers; if they can take society's money, then they can outlaw CDS events. If a bank fails, it fails; at least it won't go critical throughout the system.

The bailout does nothing for the economy. They would stand a better chance putting a floor under the housing market by making work for people.

B.T.W. The last time the US ran a trade surplus was 1991. Do you think that might have had anything to do with leading us out of recession then? How's that globalization thing working out for us?