interest rates

In Offense of Ben Bernanke, Part III: Bernanke, Blinder, and Underpants Gnomes

by Alex Schibuola on December 14, 2010

in Economy

Part I: The Fed is Competent?
Part II: The Natural Rate of Unemployment
Part III: Bernanke, Blinder, and Underpants Gnomes

Professor Blinder writes:

Here’s the first Economics 101 question: When central banks seek to stimulate their economies, how do they normally do it? If you answered, ‘by lowering short-term interest rates,’ you get half credit. For full credit, you must explain how: They create new bank reserves to purchase short-term government securities (in the U.S., that’s mostly Treasury bills). Yes, they print money. [Italics added]

But short-term rates are practically zero in the U.S. now, so the Fed wants to push down medium- and long-term interest rates instead. How? You guessed it: by creating new bank reserves to purchase medium- and long-term government securities.

I’m afraid that’s only partial credit, though. What the Federal Reserve has yet to elaborate on is why this “stimulates” the economy. You should know, Professor Blinder, that investment appears to be interest-rate inelastic. You wrote this in your journal article, “Is There a Core of Macroeconomics That We Should All Believe?”

The claim that QE2 is supposed to “stimulate the economy” bothers me. For those of you who watch the TV show, South Park, it reminds me of the underpants gnomes episode. The gnomes collect underpants and give the following explanation for why:

Underpants Gnomes:

Phase 1: Collect underpants.

Phase 2: ???

Phase 3: Profit!

Bernanke and Blinder:

Phase 1: QE2.

Phase 2: ???

Phase 3: Economic recovery!

I still want a better explanation for Phase 2… from the Fed. They say they want to be clear and explain their thinking, but I have yet to hear an explanation other than that.

If you want a more sane explanation for QE2: one could point out that many of the Fed’s current assets are maturing. This means that cash will be flowing back into the Fed and they want it out. Thus, the Fed is trying to keep its balance sheet steady rather than expand it per se.

I surmise that they intend to raise the opportunity cost of holding Treasuries, thus making private sector debt and equities relatively more enticing to hold. Then banks go back to private lending, commercial paper, corporate bonds, etc., and investment expands. So it looks like the people at the Fed have discovered a free lunch. But as ECON101 teaches us, Professor Blinder, There ain’t no such thing as a free lunch!

In Offense of Ben Bernanke, Part II: The Natural Rate of Unemployment

by Alex Schibuola on December 14, 2010 · 2 comments

in Economy

Part I: The Fed is Competent?
Part II: The Natural Rate of Unemployment
Part III: Bernanke, Blinder, and Underpants Gnomes

Professor Blinder writes: “All in all, it looks like the nation and the world need an Economics 101 refresher. So let’s start with the basics.”

All in all, it looks like Professor Blinder needs an Economics 101 refresher too. So let’s start with the basics.

There are three types of unemployment: (1) frictional, (2) structural, and (3) cyclical. I am frictionally unemployed if I leave my current job and take time off before starting my new one. I am structurally unemployed if I lose my job to globalization or minimum wage increases, etc. I am cyclically unemployed if the economy is in recession.

Keynes referred to cyclical unemployment in proposing his solutions. The Fed might be gravely mistaken to assume that today’s high, persistent unemployment rate is purely cyclical. The Fed can only impact cyclical unemployment, not structural or frictional. The sum of frictional and structural unemployment is the natural rate of unemployment. The Fed cannot alter this.

There are many reasons why structural unemployment rather than cyclical unemployment might be at play:

  1. Exchange rates are more volatile: unpredictable monetary policies and debt crises are the cause. If I am in an industry that relies heavily on exports, I am in danger of unemployment.
  2. Health care reform: the costs have yet to be determined and increase employment costs. Needless to say, employers care about the total costs of hiring employees, not just the money wage/salary they pay workers. This uncertainty overwhelms the tiny tax credits offered in the stimulus package.
  3. The housing market is still sick. If people can’t move easily, labor mobility is constrained. It’s more difficult for me to find work if I can’t move.
  4. Higher, extended unemployment benefits reduce the incentive to be employed, at the margin.
  5. The Dodd-Frank Act also imposes numerous uncertainties on the financial sector. This complicates the process of linking savers with investors. Consequently, investment is curtailed and higher unemployment results.
  6. The uncertainty about the capital gains tax rate didn’t help. Increasing taxes on capital decreases capital accumulation (investment). It does not help it. If productivity-increasing equipment costs me $200,000 and I’m willing to pay $250,000 for it, that’s great! If I have to pay a $60,000 tax on it, that’s bad: The equipment now costs me $260,000 and I was only willing to pay $250,000 before. Now I won’t buy it. I am worse off. The equipment supplier is worse off. The employees of the equipment supplier are worse off because they’ll need fewer workers for production.

If 10 percent is the new natural rate of unemployment, then fiscal policy simply crowds out private investment — private sector spending declines 1 for 1 with increases in government spending in that case. Monetary policy is completely impotent.

In Offense of Ben Bernanke, Part I: The Fed is Competent?

by Alex Schibuola on December 14, 2010

in Economy

Professor Blinder writes: “To create the fearsome inflation rates envisioned by the more hysterical critics, the Fed would have to be incredibly incompetent, which it is not.”

First off, I’ll admit that critics of Dr. Bernanke may use bad logic. Nevertheless, a good economist will tell you that people are rationally ignorant: The opportunity costs of becoming an expert at everything, such as nuclear physics, foreign policy, and macroeconomic policy are very high. Consequently, people take many mental shortcuts. Politics is no exception.

Politicians fill this void usually by concluding an argument such as, “that so and so is a Nazi.” Translation: “so and so” or “such and such” policy is bad. In econ-speak: the costs exceed the benefits to society. While the applied logic of politicians and pundits may be (probably) wrong, it doesn’t mean that Dr. Bernanke and the Federal Reserve don’t warrant criticism.

Now, truth be said, I believe Dr. Bernanke to be a first-rate academic and a very well-intentioned person. However, I doubt his ability (or anyone’s for that matter) as Federal Reserve chair. After all, they’ve been tasked with a fool’s errand: maintain full employment and a stable price level — and if there’s time, to maintain stable long-term interest rates. Underlying this is the premise that they can find the market-clearing interest rates better than the market itself.

You should give the Fed more credit, Professor Blinder. They failed in the early ’20s, they created and exacerbated the Great Depression, they let inflation get out of hand between the ’50s and ’80s, and there are strong theoretical propositions pinning the stock-market bubble of the 1990s and the housing bubble of the 2000s to the Federal Reserve.

If you were to read former Federal Reserve Governor Frederic Mishkin’s textbook on money and banking, one chapter documents how every decade since its inception, the Fed always found a new way to mess up. The Fed is just not that great.

Professor Blinder writes: “All in all, it looks like the nation and the world need an Economics 101 refresher. So let’s start with the basics.”

Let me conclude Part I by stating: All in all, it looks like Professor Blinder needs an Economics 101 refresher too. So let’s start with the basics.

See also:
Part II: The Natural Rate of Unemployment
Part III: Bernanke, Blinder, and Underpants Gnomes

Another Reason Why Fannie Mae and Freddie Mac Need to Go

by Alex Schibuola on October 26, 2010

in Bailout Watch, Economy

The monthly payments a home mortgage has depend on two variables (among others): the initial down payment and interest rates. A larger down payment means a lower mortgage balance; this results in lower monthly payments. Lower interest rates lead to lower monthly payments.

A 2006 study by Fannie and Freddie finds that, by virtue of their existence, homeowners pay 30 basis points (bps) less on interest rates (e.g., a 5 percent interest rate = 500 bps).* The study also highlights how they permit greater homeownership by offering mortgages that require lower down payments. Further, they “estimate the total savings to homeowners from Freddie Mac and Fannie Mae activities reach the $18.8-26.9 billion range.”

That’s an interesting number. But what does this mean for an individual homeowner? I created an amortization table to see:

In World A^, without Fannie and Freddie, a homeowner purchases a $200,000 home with a $40,000 down payment and takes out a $160,000 mortgage with a 5 percent interest rate.

World A monthly payment: $858.91

In World B^, with Fannie and Freddie, a homeowner does the same as in World A, except he or she pays a 4.7 percent interest rate instead (30 bps lower because Fannie of Freddie exist).

World B monthly payment: $829.82

In World C^, with Fannie and Freddie, a homeowner purchases the same home with a lower $20,000 down payment and takes out an $180,000 mortgage at a 4.7 percent interest rate.

World C monthly payment: $933.55

Between World A and World B, which have different interest rates but the same down payment, the homeowner saves $29.09 per month ($349.09 per year). This is ludicrous. At the individual level, one cannot justify saving $29 per month after incurring losses of hundreds of billions of dollars at the expense of all taxpayers.

Between World A and World C, our prospective homeowner is actually worse off because of Fannie Mae and Freddie Mac. Because the down payment is smaller, the mortgage balance is larger thus increasing monthly payments. The homeowner ends up paying an extra $74.64 per month ($895.68 per year) because of Fannie and Freddie. This is super-ludicrous.

Not to be naïve, the homeowner in World C, might not be a homeowner at all, because he or she may not be able to raise $40,000 to buy a home in today’s World A. However this person would be better off renting and saving up for a down payment in the future. In either event, given that the micro-level effect of Fannie Mae and Freddie Mac’s existence is so small or even harmful, they need to go.

*The Federal Reserve estimates (Passmore 2005) that it’s actually only a 7 bps advantage bestowed by Fannie and Freddie. I’m being nice, though, and giving Fannie and Freddie the benefit of the doubt.

^Assumptions: 30-year fixed-rate mortgage. $200,000 is purchase value of home. 5 percent and 4.7 percent are annual interest rates which are then adjusted for 12 monthly periods.

Congress Mulls More Credit Card Restrictions, in Legislation Likely to Backfire on Consumers

by Hans Bader on January 5, 2010 · 3 comments

in Deregulate to Stimulate, Economy, Legal, Politics as Usual, Precaution & Risk, Sanctimony

Some in Congress want to impose interest rate ceilings on credit cards and restrictions on interchange fees.  Australia tried the same thing, and it backfired, harming consumers by forcing credit card companies to increase annual fees on responsible credit cardholders and scale back rewards programs.  (Ironically, recent interest rate hikes are partly the product of a law recently passed by Congress, the CARD Act, which forces responsible people to bear the costs of irresponsible borrowers.)

As law professor Todd Zywicki notes in the Wall Street Journal, the proposed legislation would harm both consumers and small businesses, since it would

reduce the quantity and quality of credit cards by restricting credit availability and cutting back on product innovation or ancillary card benefits. This is exactly what happened when Australian regulators imposed price controls on interchange fees in 2003: Annual fees increased an average of 22% on standard credit cards and annual fees for rewards cards increased by 47%-77%. Card issuers also reduced the generosity of their reward programs by 23%. Innovation, especially in terms of improved security and identity-theft protection, was stalled. Card issuers also increased their efforts to attract higher-risk customers who generate interest and penalty fees to offset lower interchange revenues from lower-risk transactional users.  The most important pro-consumer innovation in payment systems of the past two decades has been the general disappearance of annual fees on most credit cards. Cardholders now carry and use multiple cards at little or no cost. The consequences for consumer choice and competition have been profound—card issuers compete for consumer business literally every time they open their wallet to make a purchase.  Annual fees are essentially a tax on card-holding. Policies that produced a return of annual fees would strangle this process of competition by making it more expensive for consumers to hold multiple cards and to switch cards easily. Small businesses, three-quarters of which rely on credit cards, would also have to pay more to maintain access to multiple credit lines, stifling the most potent engine of economic recovery.

Earlier, Congress and the President misguidedly attempted to reduce burdens on irresponsible credit card borrowers, through a new law, the CARD Act of 2009 (Credit Card Accountability Responsibility and Disclosure Act), that backfired and resulted in the return of annual fees, bizarre interest rate hikes for some responsible borrowers, and the elimination of many cash back and rewards programs.

All these bailouts are taking their toll on the economy.  Economists and real estate experts say a $75 billion mortgage bailout program devised by the Obama administration is actually harming the economy, the housing market, and the construction industry.

LibertyWeek 75: Credit Cards, Government-Style

by Richard Morrison on January 4, 2010

in CEI Projects, Podcast

Richard Morrison, Jeremy Lott and Marc Scribner get together to bring you Episode 75 of the LibertyWeek podcast. We take on Ben Bernanke’s recession theories, Canada’s struggle to provide affordable energy, the high cost of government-regulated credit cards, bringing booze to Salt Lake City and the FDA’s critics on the left.

Regulation of the Day 93: Predatory Lending

by Ryan Young on January 2, 2010 · 1 comment

in Deregulate to Stimulate, Economy, Regulation, Regulation of the Day

Congress has used the financial crisis as an excuse to regulate what it calls “predatory lending.” As so often happens, its new regulations have had unintended consequences.

A bank in South Dakota, in order to comply with the new rules, is charging 79.9 percent interest for one of its low-limit credit cards. The pre-regulation rate was 9.9 percent.

The Credit Card Accountability, Responsibility and Disclosure Act of 2009 makes it illegal to charge annual fees greater than a quarter of a card’s limit. For small-balance cards, the allowable fees are tiny now. That leaves banks with three options:

-1. Lose money. The Wall Street Journal correctly notes that “Banks can’t be expected to give money away, even if Congress is in the habit of doing just that.” So this option is unlikely.

-2. Stop offering low-limit cards. This will hurt people who need them, such as people with low incomes, people with bad credit records, and young people who are trying to establish a credit record.

-3. Charge higher interest rates to make up for the money lost in fees. This is exactly what is happening here with the 79.9 percent rate for a $250-limit card.

If the bank calculated correctly, the 79.9 percent rate will be roughly a wash compared to the earlier high-fee, low-rate policy. But different customers will be paying. The people who incur a lot of interest-rate charges are usually the people who can’t afford them. And they’ll be paying a lot more than they were before the CCARD Act.

People who can afford to pay their balances on time often don’t pay little or no interest interest anyway. The 79.9 percent rate doesn’t really affect them. And now their annual fees have gone way down. The CCARD Act is, completely unintentionally, a wealth transfer from poor people to richer people. Congress is actively hurting the very people it intended to help.

Stimulus Package Shrinks Economy, Destroys Private Sector Jobs

by Hans Bader on May 31, 2009 · 2 comments

in Bailout Watch, Economy, Employment, International, Labor, Odds & Ends, Politics as Usual, Precaution & Risk, Stimulus to Nowhere, Trade

Most of the $800 billion stimulus package has yet to be spent, but it’s already harming the economy, both by triggering trade wars that have cost at least 40,000 jobs, and by driving up interest rates for businesses that need to borrow money to expand or create jobs. (The government is keeping down interest rates on its own debt by printing vast sums of money to buy its own bonds, in order to finance the exploding national debt, which will result in massively higher taxes).

As economist Arnold Kling explains, “most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy. According to this standard analysis, the stimulus is going to hurt GDP now, when we could use the most help. Much of the spending will kick in a year or more from now,” when the economy will already be in recovery, and “when the economy will need little, if any, stimulus. This is the flaw with using spending rather than tax cuts as a stimulus. The lags are longer when you use spending. Of course, if the real goal is to promote government at the expense of civil society” through “political favoritism, then the stimulus is working exactly as intended.”

1.2 million Americans have lost their jobs since Obama signed the stimulus package into law. The Congressional Budget Office predicted it would shrink the economy “in the long run” (contrary to Obama’s claim that it would prevent “irreversible decline“), but create jobs in the short run.

But the stimulus package turned out to be harmful even in the short run, because it was so badly designed. It poured money into sectors of the economy where no help is needed because unemployment is low, while siphoning money out of sectors where unemployment is high. Moreover, “states hit hardest by the recession are getting the least amount of stimulus spending.”

The stimulus package is just one example of the Obama Administration running up the national debt to bail out the more fortunate while sticking less fortunate people with the bill. The auto bailouts are another. They run up the national debt to keep unskilled auto workers enjoying wages and benefits that are much better than those enjoyed by the average American (while ripping off pension funds and bondholders). As Mickey Kaus notes, “Why should the government tax unskilled workers making $18 an hour, who haven’t bankrupted their employers, in order to protect unskilled workers making $28 an hour, and who have bankrupted their employers, from having to take a pay cut?” (Actually, the Chrysler autoworkers are making far more than $28 an hour, when you factor in benefits).

The stimulus package has directly destroyed tens of thousands of jobs. A provision in the stimulus package that blocked a mere 97 Mexican truckers from U.S. roads “caused Mexico to retaliate with tariffs on 90 goods affecting $2.4 billion in U.S. trade,” destroying 40,000 American jobs. And its vague “buy American” provisions, despite doing little to promote purchases of U.S. products, managed to ignite a trade war with Canada.

Obama’s policies echo those of Herbert Hoover, who helped spawn the Great Depression through his protectionism and tax increases. One of Obama’s own advisers admits that “the barrage of tax increases proposed in President Barack Obama’s budget could, if enacted by Congress, kill any chance of an early and sustained recovery.” Even the Washington Post, which endorsed Obama and once supported his auto bailouts, now has soured on them and their waste of taxpayer money.

Fred L. Smith, Jr. on Credit Cards

by Richard Morrison on May 12, 2009

in Video, Zeitgeist

[youtube:http://www.youtube.com/watch?v=rKNBLsEzJmw 285 234]

D.C. Event: BB&T’s John Allison on the Financial Crisis

by Richard Morrison on January 15, 2009 · 1 comment

in Bailout Watch, Economy, Stimulus to Nowhere

Our friends at the Ayn Rand Center for Individual Rights are hosting what promises to be a fascinating public lecture on the state of the U.S. economy and what it means for the future of capitalism. Former CEO and current Board Chairman of BB&T bank, John Allison, will explain the interventionist government policies that brought us where we are today and their anti-capitalist underpinnings.

Location and Details:

The Financial Crisis: Causes and Possible Cures
Thursday, January 29, 2009

National Building Museum—Great Hall
401 F Street NW
Washington, DC 20001
Red Line Metro, Judiciary Square

Doors open: 6 PM
Lecture and Q & A: 6:30 PM

This event is FREE and open to the public.