Yip Yap Times

Folly of a Politically Managed Economy

According to the Bureau of Economis Analysis, United States real gross domestic product (discounted for inflation) grew by an annualized 4.9% in the third quarter 2007. That's even better than the 3.8% growth rate reported for the second quarter of 2007--good growth despite the ever weakening dollar and rising oil prices. Yet the media and various financial pundits relentlessly predict imminent recessionary doom due to the "housing crisis" unless the government steps in with a massive bailout for lending institutions and defaulting homeowners. The political pressure must be very great because even Fed Chief Ben Bernanke has succombed repeatedly to pressure to reduce the federal funds rate despite being the boss of a completely independent national banking arm. But the macro-problems of bailouts and Bernanke's thinking, beyond screwing people who have wisely adhered to the Shakesperian maxim of "neither a borrower nor a lender be," is the increasing tendency toward greater central planning of the economy.

On the surface, firms like Countrywide have laid people off amid losses and have demanded that the government (taxpayer) take care of their (irresponsible blunders) losses. Hedge fund managers are screaming about bankruptcy and demanding that the Fed drop interest rates as low as necessary to reinflate the housing bubble to cover their losses. The entitlement champions are shrieking about the difficulty of getting home loans and all the unfortunate Americans who will lose their homes if the government (taxpayer) doesn't pay for it. Isn't owning a home a right, they insist? No my children, it is a privilege and a great responsibility--as everything should be in a society where people want to be free to choose. Nowadays, responsibility for one's actions and choices is anathema to the crybaby '60's generation and the children they've raised.

The federal funds rate directly impacts lending and savings rates. If you're a borrower, you love lower rates; if you're a saver, you hate them. First, let's do the Reader's Digest review of basic macroeconomics. Economic growth in the U.S. is driven by consumer spending which accounts for 2/3 of it. So corporate America and the government want to make coming by money very easy for the consumer so that he can spend more. This necessitates borrowing more, unfortunately. When the consumer demands more, businesses produce more. When productivity goes up, the laborers' wages go up. To produce more, companies generally hire more workers. When demand outruns labor, the unemployment rate drops, prices go up and businesses make more profit, which hopefully reduces the unemployment rate.

The 17 rate cuts Greenspan authorized from 2001 to 2004 were intended to make money so cheap businesses couldn't refuse to borrow so that such debt would hopefully jumpstart the cycle I described above. But the unexpected consequence was the tremendous drop in mortgage rates that drove an almost panicky demand for housing. This was the primary factor that kept the economy afloat. However, it seems that the demand was artifially created because interest rates were too low for too long which created a real estate bubble.

Low mortgage rates cut into the profits of lending institutions, but because rates were low, demand for loans skyrocketed. I suspect that because lending institutions were earning volume based profits, due diligence for risky borrowers not only took a backseat, it ended up in the trunk. Lending institutions used teaser rates in adjustable rate mortgages (ARM) to entice subprime borrowers who should never have owned a home in the first place. But housing prices continued to climb and foolish people borrowed against the equity in their homes assuming the values could only continue to go up. When home prices dropped and the ARM reset--oops. You'd think that seasoned bankers, a normally risk averse bunch, would recognize that what goes up must come down. Now, finally, the banks and other lending institutions are tightening up requirements for their loans. Nothing like closing the barn door after the horse escaped.

Why are the hedge funds so upset? Didn't they hedge their bets? Let's do another Reader's Digest type of tutorial. In order to "create" more money for loans, financial institutions securitize loans. That is, loans are repackaged as investment grade securities and sold to investors. Due to the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. Hedge funds create "derivatives" which are financial instruments based on the value of their underlying assets. So, in this market hedge fund managers created options and futures contracts assuming that the underlying value of these securities would continue to increase in value. These kinds of contracts allow for leveraging, which is a fancy term for borrowing against an asset in the hope that it will increase in value and hence make more money that investing only what you have. To illustrate, say a homeownver borrows against the equity in his home and dumps the money into a stock market that has been bullish for a while. He is betting that the market will continue its upward performance and he hopes to make a profit several times larger than the debt on his equity loan. The hedge funds' lost their bets--oops. The hedge funds among others have continued to pressure the Fed to reinflate the housing bubble and the Fed has obliged despite the fact that bubbles do not promote economic stability.

Is a bailout good economic policy? Some commentators believe that any measure that keeps the unemployment rate low is good policy. But government regulation cannot take the place of the function of a free market. The free market is smart--it knows how to correct and maintain overall balance, even if financial measures fluctuate a bit in the process. Government involvement distorts the market and starts an avalanche of unexpected results that will take much longer to correct, if that is even possible as government solutions add layer upon layer of bureacratic sediment.

The so-called "housing meltdown" and "financial crisis" (and other inflammatory descriptors) only affects 4% of borrowers. That means 96% of borrowers pay their mortgages on time. The subprime sector has only a tiny affect on the overall economy in absolute terms but economists and financiers talk about the trickel through effect of losses on investors and consumers. For example, investors may want to dump stocks and consumers want to hang on to their money for fear of job loss and loss of home equity. Since the beginning of the housing bust we have seen instability in the stock market that many analysts say is a direct result of the "housing financial crisis." But the enormous majority of stocks in the market have nothing to do with the housing market or the lending institutions.

I realize that monetary policy is the Fed Chief's legitimate purview, but it seems that he is using it in a manipulative manner to satisfy the political pressure of the few but powerful that run a relatively small part of the economy. As Greenspan did, Bernanke uses the stock market as a measure of the health of the economy. The value of a stock is affected by its earnings expectations, which are also driven by "irrational exuberance" or irrational pessimism. This is the folly in using the market as primary data for policy formulation. Monetary policy is not meant to drive the market or bailout bad investments; it is meant to create price stability which is a major factor in earnings expectations. In the meantime, wise savers are are forced to subsidize the hubris of the mortgage industry in the form of crappy returns on fixed-income investments.

At the same time, Bernanke seems to be ignoring one of the most basic laws in free market economics: savings equals investment. I wonder how much the Fed would have been needed as the lender of last resort, or how much more money would have been available for loans to good risks, if the savings rate in this country was much higher. I suppose it depends on the government's fiscal philosophy. Consumption drives our economy; debt drives it harder, so let's "spend our way to prosperity." But an economy built on consumer debt and profligate spending is like a house built on sand rather than rock--makes an unstable foundation. I believe balance between spending and saving with less emphasis on debt will drive the economy just as successfully and without so many of the boom-bust cycles that seem to be increasing in frequency.

Is a bailout in keeping with the principles of self-reliance, responsibility, and risk-taking that built this country? I am sorry for investors who have lost money but that is the risk when one is looking for rates of return that are substantially higher than risk free investments like T-bills. In a free market economy there will always be good invesment opportunities but "you got to take the bad along with the good" as my mother used to say. Hedge fund managers who have lost a bundle in the subprime carry the same burden. It's too bad there are some who will lose their houses because of default, but as my daddy always said, "if you can't afford it, you don't need it." The lending institutions that have been making these risky loans especially need to suffer the consequences in keeping with the principle of responsibility. Responsibility is the price of freedom. Refusal to accept it is inversely proportional to the freedom we will have. Sure, it's tempting to demand government rescue as largess to be reaped at will, but we as a nation will have to pay the proverbial piper one way or another. We have to get control of the pervasive greed in this country and get back to fundamentals like "slow and steady wins the race" and flee the selfish "I'm gonna git mine and git it right now."

But the worst, perhaps even unconstitutional, government interference in the free market is President Bush's plan to freeze ARM rates as part of the bailout. The Contract Clause appears in Article I, section 10, clause 1 of the U.S. Constitution:

"No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, expost facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility."

The framers of the Constitution added this clause due to fear that states would continue a practice that had been widespread under the Articles of Confederation—that of granting "private relief." Legislatures would pass bills relieving particular persons of their obligation to pay their debts. Interestingly, with all the yip yap the Democrats have been doing regarding the unconstitutionality of national security measures and the constitutionality of measures no where mentioned in the Constitution, they disregard this constitutional provision that is written in stereophonic black and white and make lots of noise about how the president has not gone far enough. What is far enough--gifting defaulters their homes at taxpayer expense?

By cutting the interest to satisfy the few, wise savers are forced to subsidize profligate behavior found in both the financial institutions and the borrowers. Government interference in the free market in the form of bailouts foreshadow a possible paradigm shift toward greater central economic planning. And we know how well that worked over a 70 year period.







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posted by Lisa @ 8:37 AM