Dean Baker Talks to His Inner Hayek
Dean Baker wrote:
Several Bush administration officials have suggested reducing mortgage interest rates to 4.0 percent, or possibly lower, with the intention of boosting the housing market. While there are markets in which it would be reasonable for the government to intervene to prevent a downward spiral of house prices, it is difficult to see anything good that would come from delaying a full adjustment in the markets that have still yet to fully deflate.
If extraordinarily low mortgage rates can succeed in preventing prices from falling back to trend levels, then house prices in these markets will presumably plummet when the economy recovers and mortgage interest rates return to more normal levels...
I disagree.
The mortgage interest rate is made up of four things. Compensation for inflation--call it 2% per year. Real time preference--the fact that because we will be richer in the future we value future goods at less than par in terms of present ones--call it 2% per year. The default discount--which in a well-run housing market should be small. And the risk discount--the extra return mortgage lenders demand because they are not sure when their payments are going to come exactly or what they will be worth exactly when they do come--and I am under the spell of Richard Thaler and Matt Rabin who argue that this discount should also be very small.
Thus I think that 4.0% per year is what mortgage interest rates ought to be. There is no higher "normal" that they ought to return to. The fact that they are not at 4.0% on average is a sign of a significant market failure--a failure to appropriately mobilize the collective risk-bearing capacity of the y.
But a 4% mortgage rate would push up housing prices. Wouldn't that tend to make housing less affordable? No--because it would also push down the mortgage payment you would have to make to carry a mortgage of a given principal amount. And the two effects should offset each other.
So I say: unleash Fannie Mae and Freddie Mac. Let them borrow at the Treasury rate and buy and buy up mortgages until the mortgage rate is down to inflation plus 2% per year. That seems to me to be a good use of public money--and in all likelihood a profitable one.
Gosh, I thought that there was no such thing as a "normal" discount rate. Don't discount rates reflect prevailing profit margins? If profit margins are close to zero, wouldn't the stupifying spread between Fed rates and corporate bonds reflect a whopping discount for inflation and risk? Is there something wrong with that based on current concensus? Isn't the attempt to interfere with that rate at best a short term distortion that the market will correct for at the most inconvenient moment?
And wouldn't the risk premium for current real estate prices given its rent ratio still indicate further erosion in value to 80/20 loans? Wouldn't that imply a risk premium in addition to "normal"?
And wouldn't the current economic forcast suggest difficulty in projecting risk of default by Prime, much less Alt-A borrowers?
4%?
Though the topic is economic the audience, well, I am confused by your statement.
December 15, 2008 7:39 PM | Reply | Permalink
Compensation for inflation--call it 2% per year. Brad DeLong
Talk about a cavalier assertion!
Note: And DeLong's entire argument depends on the accuracy thereof.
December 15, 2008 7:48 PM | Reply | Permalink
Wow. When the elephants fight the small animals....had better stay out of the way.
From behind a rough stone wall I vote with DeLong.
(now hiding again)
December 15, 2008 8:50 PM | Reply | Permalink
Seems to me that this argument is also based on the notion that risk is now zero, i.e. that everyone is going to make their payments from now on, and that the houses will all be worth at least the amount that's owed on them. Otherwise there would be a big fat risk-premium number in there. Maybe Brad is assuming that the risk is negligible because the federal government is acting as guarantor, but that sounds like a big fat risk-shifting perverse incentive to me. (He's also betting against Keynes's Law of Market Irrationality, but at least he's doing with other people's money.)
December 15, 2008 9:17 PM | Reply | Permalink
The Q4 2008 Survey of Professional Forecasters pegs the long run CPI inflation rate at 2.5%:
http://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters/2008/survq408.cfm
So now we're up to 4.5%. I'm wondering whether it wouldn't be hard to bring the proper rate to 5%.
December 15, 2008 9:17 PM | Reply | Permalink
Well, I've got a nit to pick also, but its not Ellen's point.
So we move the rate down to 4%....what exactly will that do? Think it out.
Everybody in town is broke, so the local store lowers the price on gumballs to 5c. Big rush on gumballs? No.
What is the market now for a house? We have fully leveraged owners facing becoming renters again. We have first time buyers without the restored down payment reqs necessary to buy the monster homes the contractors have been building for five years. We have move-up buyers, who lack the income to qualify for our return to pre-bubble orthodoxy.
In short: There is no market. Look at the housing stock. 80,000 incomes do not buy 6,000 sq ft homes in rational markets. Lowering the interest rate will do very little to stop an avalanche of defaults in Super Prime and Alt-A as owners make the rational decision and bail out on their underwater deals.
There is only one solution to this problem. Restore the bubble. But we can't do that so we are going to have to settle on a shotgun approach that takes into account the fundamental lack of a market in a postbubble environment.
Meanwhile Fannie is going to keep people from hitting the bricks and that's a start. Doesn't solve the basic problem, but is good for balance sheets and good for consumer demand.
December 15, 2008 9:21 PM | Reply | Permalink
Oh yes, look at the newest figures for housing starts. I don't even want to repeat the figure here as it is dismaying. We are overbuilt and with the wrong kind of houses to boot. I call them "Bubble-Domes" because they presuppose everyone has an income of 200k which even McDonalds kitchen workers had to all effects and purposes once the creative financing was arranged.
But with the end of that financing, a funhouse mirror in which no matter what economic size you were, a 200k guy looked back, we have to face the reality that America is not composed of business executives ready to upgrade to 5,000 sq feet. So who now can buy all that stock? You might just as well bulldoze all those subdivisions standing empty.
So I am not impressed with regulated low interest rates as anything more than reducing only slightly the walk aways. Much more has to be done and you economists had better come up with something fast...as we are already further into the deflationary spiral than is safe.
December 16, 2008 2:45 PM | Reply | Permalink
Delong's post is yet another example of his habitual arrogance, which he dispenses with wanton disregard for any opininion straying from his neoclassical viewpoints.
So smitten with his ego, he can't help but be so boorish. Like I said, it's habitual. The only problem:
He is often wrong. Wrong about the benifits of trade regimes, wrong about immigration, and generally clueless on economic distribution.
And here he is cherrypicking from Baker without the decency to actually engage.
December 15, 2008 9:48 PM | Reply | Permalink
We have six decades of pretty good data to look back on and over that period the mortgage rate has averaged 4 percentage points above the inflation rate. But, Brad tells us that this is market failure to be rectified by the Fed's commitment to reducing the gap to 2 percentage points. (We also have the additional assumption that inflation will still at 2 percent -- far below its average over the last six decades.)
Okay, so if the government will commit itself to keeping the mortgage rate at 4 percent for the next six decades, come hell or high water, then I'm 100 percent with Brad. But somehow, I don't think that will be the case.
My guess is that we will get 4 percent mortgage rates until the economy recovers and the dollar falls and inflation picks up. Then we see mortgage rates rise to 6 percent, 7 percent, maybe even 8 percent. Who knows, maybe we'll get back to the double-digit rates we enjoyed in the 80s.
Then house prices plunge and all the people who bought homes when the rates were 4 percent get nailed. Then all the economists who thought this was great policy tell us that "virtually nobody" could have imagined that mortgage interest rates could rise, arghhhhhhhhhhhhh!
I hate reruns.
December 15, 2008 10:28 PM | Reply | Permalink
If a rerun reduces the probability of 2009 becoming 1929 it's a risk worth taking.
December 15, 2008 10:38 PM | Reply | Permalink
The mortgage interest rate is made up of four things. Compensation for inflation--call it 2% per year. Real time preference--the fact that because we will be richer in the future we value future goods at less than par in terms of present ones--call it 2% per year.
Time preference exists for several reasons, not just because we expect to be richer in the future. Time preference exists because people mostly o not like delaying gratification, and because of the inherent risk in delay - if I put off buying something I want for four years, I do not have a guarantee that I will be alive to buy it at the end of the period, or that it will be available, or that something else will prevent me from getting it.
To suggest that time preference is caused solely, or even mainly, by the expectation that the economy will grow is an extreme misunderstanding of the Austrian economics that one's "inner Hayek" would have.
But a 4% mortgage rate would push up housing prices. Wouldn't that tend to make housing less affordable? No--because it would also push down the mortgage payment you would have to make to carry a mortgage of a given principal amount. And the two effects should offset each other.
Translation - we can keep the housing bubble going forever! The housing market of the early and mid-2000s is completely sustainable!
December 15, 2008 10:30 PM | Reply | Permalink
A very interesting discussion getting started here. A 4% mortgage rate will do a lot to stabilize the housing market and get us back to normal. That has to be based on some realistic underwriting...and perhaps some changes to foreclosure law.
A less costly foreclosure process would allow banks to recoup their 80% of the value they are entitled to and lower some of the risks associated with Mortgage lending. But if the market is functioning normally a borrower should be able to sell and avoid foreclosure.
This also is not such a great idea in regions that are in secular decline (like Detroit or Buffalo). However these areas are not the norm in a growing nation like the US.
This is a hugely important issue. Fix the housing markets and you fix the banks and the credit markets. Fix those and you have the foundation to fix the economy again.
Whatever you do...don't bail out the homebuilders...we have too many homes and only time (and population growth) is going to fix that.
December 15, 2008 11:15 PM | Reply | Permalink
Where does the profit for the banks get factored in to all these calculations?
If banks aren't going to be allowed to charge usurious rates on credit cards, meaningless fees and create mortgages with balloon payments how are going to create the level of earnings that investors demand?
Will you invest in a bank that has little business growth and returns 2-4% a year in dividends? Why would you, you will be able to get these types of returns from bonds and other low risk investments.
People have been demanding (expecting?) outsized returns of 10-15% for decades and Wall Street has been taking on ever riskier schemes in order to fulfill this unsustainable expectation. Those firms who tried to act prudently (especially mutual funds) saw their investors leave in a hurry.
Now we see that some firms have even turned to outright fraud to provide these yields. It turns out that even the wealthiest, most "sophisticated", investors also demanded impossible levels of long term returns.
As Pogo famously said: "We have met the enemy and he is us".
Unless US investors start to think like those in Switzerland we will continue to see rampant speculation and unwise business decisions.
December 16, 2008 10:41 AM | Reply | Permalink
The mortgage interest rate is made up of four things. Compensation for inflation--call it 2% per year. Real time preference . . . call it 2% per year. The default discount . . . and the risk discount . . . Thus I think that 4.0% per year is what mortgage interest rates ought to be.
Hmmm. So 2+2+x+y = 4?
Interesting math.
December 16, 2008 2:46 PM | Reply | Permalink
Yes, this is a huge assumption. Prof. DeLong's four factors can be further reduced to two: inflation expectations and an all-encompassing risk premium. You rightly note that inflation has generally been above 2%.
But the risk premium of 2% also strikes me as rather low, especially as the economy is sliding into recession. Default risk should be rising - people who are laid off have trouble making mortgage payments. Comparing the price-to-rent ratio suggests that real estate prices may have further to fall even now, suggesting another vector for default risk. And don't forget that markets which overshoot on the upside can easily over-correct on the way down.
Prof. DeLong argued default risk should be small "in a well-run housing market", which begs the question of whether the housing market is yet well-run, or has been within the past half-decade. Let's just say I'd be reluctant to make too many mortgage loans at 4% right now.
December 16, 2008 2:55 PM | Reply | Permalink