Tuesday, July 13, 2004

Columnist Watch: Taking on Brad and the FT

Brad Delong has a new piece out in the FT.

If you ask proponents of aggressive tightening of American monetary policy why it is both desirable and necessary, the answer you will probably get will point to two things: high bond prices and high property prices...

Now it is true that the prices of US bonds are hard to reconcile with standard models - especially given that George W. Bush and the Republican Congress have unfortunately seen fit to resurrect the long-term deficit monster that we all thought had been vanquished a decade ago. (Property prices, on the other hand, seem broadly compatible with bond prices: there is one phenomenon here, not two independent ones.) Someone's expectations are out of whack. If it is the bond market that is out of whack, bond prices could fall far and fast when the long run knocks on the front door to say that it has arrived.

But there is another way to look at it. If bond and property markets are indeed fragile, only minor increases in interest rates will be enough to cool off aggregate demand sufficiently to neutralise any gathering inflationary pressures. The fact that aggregate demand may well be unusually sensitive to asset prices that are unusually sensitive to interest rates is an argument that the Federal Open Markets Committee should move slowly and gingerly, not that it must move fast and aggressively.

Now it's not often that I disagree with Brad, but I have to do so strongly here. When the results don't agree with the model, then either we're seeing new economics or we're seeing an inefficient market distorted by intervention. Using Occam's Razor we can easily guess that it is the later case this time around rather than a "new economy" phenomenon. The inefficient market is spawning a bubble. To see why, we simply have to look at what happened to mortgage rates after the Fed raised rates (as of July 12th). (Baltimore Sun)
Originally published July 12, 2004
NEW YORK -- In an unexpected development, mortgage rates actually have fallen since the Federal Reserve raised short-term interest rates nearly two weeks ago.

Rates on 30-year fixed-rate mortgages have edged back close to 6 percent, after hitting 6.37 percent just before the Fed meeting on June 29.

During recent months, partly in anticipation of the long-expected Fed rate hike and concerns about inflationary pressures, mortgage rates had climbed from their near-record lows. As recently as May, rates spiked up to a national average of 6.49 percent.

But Wednesday, rates on 30-year fixed-rate mortgages fell back to an average 6.12 percent, according to HSH Associates, financial publishers in Pompton Plains, N.J., with rates on conforming loans even lower. The drop in rates took both lenders and borrowers by surprise.

"The expectation was that we would be above 6.5 percent, based on a stronger economy," said Jim Ferriter, a retail mortgage executive with Chase Home Finance, a unit of J.P. Morgan Chase & Co.

The market is signaling that it expected more aggressive tightening from the Fed. Failing that it fell in line with the Fed's move. This was a fall back toward levels that would feed a speculative asset inflation bubble. Many bubble watchers including me have already declared a bubble in the housing market. However the market signaled something different.

What it signaled was that there was still time to avert a true bubble. Bubbles are like inflation, their cousin, in that once you realize you're in one it's too late to get out without a lot of pain. What the market signaled is that we still could have avoided a housing bubble. Given the course that the Federal Reserve has set, it's now signaling that we're going to be in.

How can I tell that? For Mortgage rates to fall there must be an influx of creditors willing to supply credit or a slackening of demand. Since housing numbers show that there is no appreciable slackening of demand, the result must be of increased lending risk and liquidity supply. This credit supply to expand means that a true asset inflation bubble will be fueled.

Anecdotally you can see it all around, in the expansion of interest-only mortgages, in the signs I see up for "Cash for Houses", the overvaluation of equity markets through manipulation and other maniacal bubble-driven behaviors. Imagine that, paying only interest and not principal on your mortgage. Or speculators willing to pay cash for properties. These are clear signs of a speculative credit-fed environment.

The purpose of the Federal Reserve is not to ensure full employment. Even if it were, short term credit binges are not the way to create sustainable job growth. Every dollar that goes into these speculative arrangements has a very low eventual economic equity building contribution to the economy. It is better to have slightly higher interest rates, lower economic growth, and create real asset values, net surplus production, income, equity increase, etc. Slow but steady is the rule. Too low interest rates only divert investment toward speculative asset groups as opposed to purchasing long term valuation expectations. People are gambling in the short term instead of investing for the future.

The necessary part of the "business cycle" creates a credit scarce situation where inefficient capitalization is liquidated. This makes the remaining companies sounder and makes room for new entrants to the market. Borrowing cheap money to stay afloat, like as in the expansion of the junk bond market, just means that capital is tied up in inefficient ventures. The correct solution is social insurance in the form of unemployment benefits, educational retraining programs, relocation and job finding assistance, government-guarenteed loans for small business startups, and infrastructure restructuring investment such as fixing the electrical production and distribution grid.
Last week, investors pumped about $440 million into junk-bond mutual funds, according to AMG Data Services. This was up from a revised $2.15 million the week before. This was the fastest rate of inflow since the week ended June 2, when investors plunked down $563 million in junk-bond funds.

One major reason is that performance has come back for this asset class. The Merrill Lynch High Yield Master II Index has climbed nearly 4 percent since mid-May, according to Reuters

This is the quick and easy way, which leads to a bubble and a crash. You can not fix an economy or assist its restructuring by flooding it with credit. Eventually there will be a consequence, and that consequence will no longer be able to softened into a "soft landing" where the markets trade sidewise until fundamentals catch up. Instead the only choice will be a correction (or "crash") in the form of either hyperinflation or massive economic contraction. In parting I will emphasize a fact my dad taught me early, and it seems even august economists like Brad need to be reminded of:

"Money doesn't grow on trees."

He's a prominent economist and I'm just some cranky guy trying to change careers. However his kind of advice is going to have deadly results for our nation's economy. Not tomorrow, and not the day after, but within a short period of time - months or at most a few years. I saw the writing on the wall the day I started seeing advertising for these "interest-only mortgages", "Cash for Houses" signs sprout up, and the mortgage rates fall after the Open Market Committee raised rates. If we weren't in a bubble before, we are going to be in one now.

I'd probably half to give an arm and a limb to get into Brad's Doctoral Thesis Ph.D. program for Economists and several years of my life to get him as an adviser if I were to try to change careers to become an economist. But in this case, he's wrong and I'm right. It doesn't give me any pleasure to say so, since the result is going to be a lot of pain for a lot of people.


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