Counterparties: DC’s mysterious decision-making

By Peter Rudegeair
August 1, 2012

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You will have been disappointed this week if you thought policymakers with doctorates in economics would be capable of using cost-benefit analysis. First there was Ed DeMarco’s decision not to allow principal reduction for mortgages held by Fannie and Freddie Mac. The benefits here were clear: mortgage relief for 500,000 borrowers and net savings for the taxpayer of about $1 billion; not to mention, as Paul Krugman noted, the “positive effects on the economy of debt relief”. DeMarco, however, thought these benefits were outweighed by the specter of higher mortgage costs, lower availability of mortgage credit and a greater number of strategic defaulters.

It’s hard to see how DeMarco came to that decision on empirical grounds. As far as higher costs and less credit are concerned, “the horribles aren’t particularly horrible,” as Felix wrote yesterday. And if you believe Treasury, the risk to a homeowner of having his request for principal reduction denied far outpaces the reward from a potential strategic default:

a borrower who defaults cannot be certain that he and she will obtain a HAMP modification, much less … principal reduction. Therefore, a borrower would take a substantial risk by deliberately defaulting: they would have to choose to damage their credit for years to come and perjure themselves on the chance that they would be found eligible for the program.

Ben Bernanke and the rest of the FOMC faced similarly stark costs and benefits this week when they weighed additional monetary easing: in Ryan Avent’s words, it’s a choice between “a trillion dollar output gap and 6 million unnecessarily unemployed workers,” versus “having 4% inflation for a year rather than 2%”. For Tyler Cowen, who in his own words is “more agnostic about the gains from monetary expansion than are many of its advocates,” the choice was easy: The Fed clearly should pursue a more expansionary monetary policy because “the costs of inflation, within reasonable ranges, are not very high”. Ultimately, the Fed announced this afternoon that although inflation has declined and unemployment hasn’t, there would be no new easing.

Exactly why the Fed’s cost-benefit calculus this time around differs from that of doves like Avent and now Cowen isn’t readily apparent, but in the past Bernanke has maintained that it would undermine the Fed’s credibility without producing any lasting improvements. But, as Ryan Avent wrote back in April, if Bernanke is saying that the Fed’s credibility is worth the cost of very high unemployment and a level of national income that’s below potential, then he must lay out a much more rigorous argument that supports that.

If the chairman is serious in arguing that 1) the Fed’s credibility is extremely valuable, 2) that its credibility is vulnerable to even short periods of above-target inflation, and 3) that the expected cost of putting this credibility at risk outweighs the beneficial impact on the serious, existing-right-now unemployment problem, then he really ought to explain at length his reasons for thinking all this. Point us to the research. Show us when in history a central bank in the Fed’s position has attempted to boost employment by raising inflation a bit above target for a short period of time, only to watch all hell break loose. If the argument for behaving as he has is really so clear, he ought to be able to convince us, some of us anyway, that he has a point. Instead, to date, he’s simply reached for handwaving about credibility and let the matter rest there. That’s not good enough.

Peter Rudegeair

On to today’s links:

Inefficient Markets
Algo accident: “technical issue” causes irregular volatility in dozens of stocks on the NYSE – Bloomberg

“Nearly two-thirds of annual federal spending is on autopilot and doesn’t require an annual vote by Congress” – Salon

Facebook is a great reminder that stock picking is a terrible idea – DealBook

Treasury can bypass Congress to get Senator Merkley’s housing plan started – Mike Konzcal

Twitter admits its commercial relationship with NBC was central to censorship of a critical journalist – FT

America needs to revive the “other 30%” of the economy that’s not based on consumption – Stephen Roach

The best news story, and lede, of the day, by far – Huffington Post

The Fed
The Fed acknowledges that the economy is decelerating, but takes no new action – Federal Reserve

New Normal
The financial industry may be set to lose 50,000 more jobs – The Big Picture


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Peter – You and Ryan Avent assume that additional Fed action will necessarily lead to improvement in the real economy. That’s a debatable point, and that someone could question that assumption should be “readily apparent” – just as it should be that Mr. Avent has invented a question that makes only his answer appear reasonable.

Posted by realist50 | Report as abusive

Mr. Rudegeair – any sort of cost-benefit analysis that doesn’t include considerstions of fairness and ethics, not to mention – law, is seriously defective IMO. The Fed does not create its own mandates – Congress does that. If it is to be the policy of government that some persons have their pockets picked for the alleged benefit of the larger society, then Congress has to give the green light for it – not you, FS or any other ‘know-it-all’.

The prior opinion of FS that you so lovingly cite has been trashed on its merits by damn near everyone who has commented on it. Just ’cause St. Felix said it doesn’t make it right.

Posted by MrRFox | Report as abusive

“it’s a choice between “a trillion dollar output gap and 6 million unnecessarily unemployed workers,”…”

What I am interested to know in these output “gap” is how much of the output was due to the “boom?”
There are a lot of assumptions is such a statement – when does the averaging of GDP start? tates/gdp-growth-annual

There hasn’t been a period of 6% growth in almost 30 years, yet many of these average GDP growth rates used as a basis of the “output” gap are as unrealistic as me saying I should still be able to buy a new car for 2,000 dollars.
Or, another interesting “average” that seems to have profoundly changed: ies/USAEPP
With a 20 year perspective, it seems we are not nearly utilizing our workers. But use a longer perspective, and we are considerably OVERemployed compared to 1970.

Posted by fresnodan | Report as abusive

Interesting question, fresnodan!

I think you have to assume that growth was artificially and unsustainably inflated during both the bubble and the housing bubble.

That suggests “normal” GDP growth in the 2% range, no?

Posted by TFF | Report as abusive

@realist50: “isn’t readily apparent” applies to what arguments the Fed has explicitly made, as opposed to arguments that the Fed could theoretically make.

The Fed has said “No”, and they might be correct, but it isn’t readily apparent why they’ve said “No”, because they have not laid out their logical arguments in a clear way.

@MrRFox: You write: “If it is to be the policy of government that some persons have their pockets picked for the alleged benefit of the larger society, then Congress has to give the green light for it.”

The FHFA report said that taxpayers would save money by pursuing principal reduction programs. Please note that: FHFA assets that; it is not Felix who asserts that. If you’ve got an argument about picking pockets, that boat sailed 4 years ago when Frannie was effectively nationalized, and those are (unfortunately) sunk costs. Starting today forward, what is the cheaper solution? FHFA itself says principal reduction programs save the taxpayers money over their current (ineffective) programs. How is that picking pockets?

@fresnodan & TFF re: output gap: the current output gap is based on a U.S. Potential GDP trend that goes back to at least 1950. The bubbles of the 2000s don’t appear to have inordinately ramped potential GDP as much as you think, thus the output gap amount is less influenced by those 2000s bubbles that you are positing. The current output gap is real, and it is spectacular.

Chart of U.S. Output Gap 1950-2020: w&id=3252

(just the image: ges/2.1.1-GDP-gap-OPT.jpg)

Posted by SteveHamlin | Report as abusive

Maybe the output gap simply dates back to the ’90s? For a while, the GDP gap was papered over by growth in “financial innovation”. Pushing papers with no lasting economic gain. When that bubble burst , the weakness in the real economy was exposed.

Posted by TFF | Report as abusive

@TFF: The current output gap is based on actual GDP trends back to 1950. Recent bubbles are not dragging potential GDP up so much as to distort current output gap conclusions. Even significant recessions are not too noticeable, and everything else is mere noise within that major trend.

See: ges/2.1.1-GDP-gap-OPT.jpg

via: w&id=3252

Posted by SteveHamlin | Report as abusive

@SteveHamlin, at some level I must plead ignorance. I might not even be using the terms properly.

But trend lines do not always project into the future. It is surprising that the model charted proves so robust from 1950-2007, but even that doesn’t guarantee that it is meaningful going forward. Shift the curve lower for the past decade and 2000-2007 would look like an aberration on the upside, with 2008-2012 looking like the “new normal” (if you like).

I did look up some numbers on the finance sector, which doubled as a proportion of GDP between 1980 and 2000. But it remains at record levels, so that can’t explain the shortfall. I do wonder what such a reliance on finance does to our economy — no industry does more to concentrate wealth in the hands of a few.

Posted by TFF | Report as abusive