Counterparties: DC’s mysterious decision-making
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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: