Ev Ehrlich's Everyday Economics

At Ease

Alright, let’s start with the World Series.  As I recall, I picked Texas in 7, asserting that Lee would win two games and the Texas line-up would find a way to win 2 more.  All of these prognostications had one central, shared characteristic – they were all wrong.  (I’m reminded of Alan Arkin playing “The Detective” in one of the greatest movies ever made, Little Murders – “What do these 345 homicides have in common?  They have in common three things.  One, they have nothing in common…”.)    As Ron Washington, Texas’ manager, said after the event, “They beat us soundly.”  Hell yes.  They gave you some broth without any bread, Ron.

The theme of being wrong segues gracefully to the economic issue of the moment, the Fed’s new Quantitative Easing announcement or, as economists call it, QE2.  (The “2” recognizes that the Fed did this in 2009, so it’s the second time.  And it makes the whole thing much more droll.) 

First, the background paragraph.  The Fed usually influences the economy by pegging the interest rate at which banks can borrow from it and manipulating the “Fed funds” rate, the rate at which you can borrow the least risky money for the shortest period of time – every other interest rate is a departure from that one, either by being riskier or by having longer duration.  But short-term interest rates today are pretty damn low, so if you want to goose the economy, you’ve got to come up with something else, and that’s QE2.  The Fed, under this policy, will buy longer-term assets, like 5 and 10 year government bonds, and start taking their rates down, too.  It’s a strong message – not only are we keeping rates low today, but we’re going to keep them low for a long, long time.

I support this policy – in fact, the picture shown here is an actual sign I carried to the March to Restore Sanity, one that provoked confused (and pitying) stares from most people and an occasional squeal of glee for kids who excitedly told me they were economics majors and could they take their picture with my sign.  It was as good a response as you could hope for, although I did better with one my other signs – like the guy who used to sit on the third base sided of Shea in the 1960s,  I brought several , including my show-stopping “This sign makes an Important Point.”  God, I love mass irony!

Like many of QE2’s supporters, I’m for it even though it’s not the right (or most right) thing to do.  The right thing to do is to stimulate the economy on the spending side, and to stabilize the housing market, so that families feel confident that their home is going to keep some of its value and they don’t have to live in fear of another shoe – or perhaps another shoe rack – dropping.  You do that by setting up a mortgage refinancing facility that mortgage writers can borrow from cheaply.  In fact, this kind of socialist, freedom-denying chicanery was recently proposed by Bolshevik-in-training Glenn Hubbard, who was the Council of Economic Advisors chair under President Bush II.  In my variant, which is very close to his, we’d allow everyone who hasn’t missed a mortgage payment for the last eighteen months refinance their entire mortgage – whether it’s underwater or not – at a rate that reflects the government’s low borrowing costs – 4 percent would work.  The Fed would then buy these mortgages and hold them, at least until the storm had passed. 

That’s a great idea.  Families who haven’t missed a payment after the last 18 months of hell are, prima facie, good credit risks, and letting them refinance their entire mortgage, even if their house has dropped in value, keeps them in their house, which supports housing prices and neighborhoods.  And there’s the rewarding-the-virtuous aspect of it; maybe even Rick Santelli would approve.  And it does so while freeing up families’ disposable income, which helps other consumption.

The only problem with that idea is that it’s not going to happen – pigs will fly to daylight before Washington producers that result.  It’s got everything – stimulus, socialism, a whiff of moral hazard.  The probability of the new Congress passing such a proposal is -5.

But, on the other hand, most economists near the center of the spectrum – in terms of both ideology and awareness – understand that something needs to be done, because the economy is too listless, wastefully so.  Yet all we stand to get from the new configuration in Washington is more of the same – lectures about the perils of long-term debt followed by extensions of tax cuts we can’t afford.  The policy favored by most of the electorate, or so their choices reveal, is “do nothing,” the classic, Hoover-esque prescription dressed up as setting the stage for a torrent of liberating entrepreneurial heroism.   Why the nation’s entrepreneurial spirit would be dashed by a stimulus or a wave of expedited mortgage refinancings is not clear to me, nor is what’s keeping it from cutting loose at the moment, but it shows you what I know.  Regardless, that’s one of the important takeaways of the Fed’s decision – it represents a judgment by the Fed that the political system is irretrievably broken, and that it has the choice of sitting idly by or taking its best shot.

A second point that can be made about QE2 is that, in some respects, its opponents think it will work more than its supporters think it will work.  I’m a supporter, and I’m not sure.  It will put more money into the economy and, specifically, lower interest rates over the medium and long terms.   That means it will be easier to write cheap mortgages, which goes back to the need to get the household sector of the economy and its real estate problem squared away.   A direct approach – like Hubbard’s -- would work better, but maybe this more roundabout tack will get the job done.  And more generally, there’s already a lot of money sloshing around there – we need to use stimulus to set it loose more than adding to the slosh.

But the program’s opponents think that the program is going to work so well that it’s going to lead to ruinous inflation, both in goods and in assets, like the prices of stocks.  Maybe they don’t think they think that, but ultimately they do.  Because if the program does lead to higher general inflation or a new stock bubble, it’s likely because economic growth has been rekindled.

That’s certainly the case for inflation in general.  There probably are still some diehard monetarists who believe that once you introduce more money into the system, inflation has to follow.  But we’ve learned enough about how the economy operates to relegate that to the realm of superstition.  The effect of money on the price level depends on a host of real world considerations.  Are banks lending it as fast as they can get it? Are people saving it or spending it?  Is the economy’s productive capacity booked to the brim, or does it have slack resources ready to be applied to the task of production?  And there are also the real-world considerations of the moment, such as, are there hundreds of millions of Asians, Eastern Europeans, and others around the world prepared to offer us whatever we want for, as they say, “a fraction of the price?”  The relationship between money and inflation is not like the relationship between a seed and a tree – you don’t plant money and come back at the end of the growing season to reap inflation.

So expecting a surge of inflation means expecting some positive response in the real economy.  Inflation – once it’s above the background noise level – isn’t a good thing.  But it would be a symptom of good things elsewhere.

There’s then a different inflation argument – that all this new cash swirling around will end up going into bidding up the price of stocks and other assets to irrational levels.  After all, we’re being promised that the Fed is going to keep the interest you earn on bonds very, very low for a long time.  So if you’ve got money and want to earn a reasonable return on it, you have to put your money in other assets – most obviously, riskier bonds (the below-investment grade stuff issued by more tenuous companies) or stocks.  It’s not surprising that the stock market had a big day yesterday, the day after the announcement was made. 

But what goes up usually comes down.  The Fed could be setting the stock market up for another bubble, another boom-bust cycle that will start heading south once the economy starts to recover more substantially and the need to keep these interest rates very low is no longer the paramount concern.  That’s a reasonable concern but, again, I think it’s a more theoretical danger than a real one.  If the economy does start to grow, earnings will make stocks more valuable even as higher rates make them less so.  And the Fed can use its ability to comment on the passing scene to shape investors’ expectations and, to use a word we once found appropriate in such a situation, “exuberance.”  Moreover, the newly-created systemic risk regulator created in the Seize The Means of Production Act of 2010 – excuse me, I meant Dodd-Frank – will also be on the beat.  It can use such devices as margin requirements to dial down any prospective bubble.  That’s why we created them in the first place.

I still believe in new stimulus – as I’ve said before, a payroll tax holiday, using the Fed’s balance sheet to buy new small business loans (with loss protections), a National Infrastructure Bank.  A program to accelerate mortgage refinancings and reward people who have hung tough is entirely in order as part of such a stimulus.  In fact, I could be a good segue to a long-overdue policy regarding the break-up and privatization of Fannie Mae.

The problem with QE2 is not the policy itself.  It’s that the political system appears incapable of making any kind of competent economic policy on its own.  That’s largely the doing of the Administration’s obstructionist opposition, but it was the Administration’s job to manage them and it couldn’t do it.  So we’re left with the Fed doing what it can in the government’s absence.  Ultimately, to my mind, the risk is not that the Fed fails, but that the Administration’s opponents in the new Congress decide that the Fed is a fair political target (see Ron and Rand Paul, but not my favorite Paul, Les), and truly damage the country by putting it in play.  Just when you think it couldn’t get scarier…