QE3?

So now we get to the part where we take a substantive look at QE2, and make a criticism. This follows my previous post: Taking Down the QE2 Straw Men

As nifty as the 2-5 year range is for job creation with it's double whammy of durable goods and small business lending, might there be better places for the money the Fed is printing to go? And now we finally get to a reasonable critique of QE2.

A question you have to ask is are there people out there looking to buy durable goods but are being held back from doing so simply because they can't get a good enough rate on the financing? Another: are there entrepreneurs out there refraining from starting new business because they can't get the financing?


Disposable Income

With respect to the entrepreneurs-- I suspect the answer is yes. However, I suspect that the reason for that has less to do with the specific rates being offered, and more to do with how bankers are doing business in the post-crash era, which I'll get to.

With respect to durable goods? Are there people looking to buy new cars, if only they could shave a percentage point off the financing? Are there people looking to buy new refrigerators, or new stoves, new computers or any other bulky, high-priced items because the interest on the financing is too high? I don't think the answer to that is yes; I think that's pretty much a no. People are making due with the computers they have because they don't have the cash to really seriously start thinking about buying a new computer. Same goes for other durable goods.

This goes across the board for durable goods; people are even buying used cars because it's cheaper, and they aren't making enough to justify the purchase of a new car. This is a problem of disposable income-- the income people make above and beyond what it takes to pay their bills, to spend on new things. And the problem here is that their debt is too high; they've got to make payments on mortgages for more than their house is worth. They've got to pay off the loans they already have, and the credit cards they ran up, and all that debt they accumulated during the easy-credit boom. What you want is something that allows consumers to lower their monthly payments on the debt they have. Lowering those payments gives them more money to spend while still paying their bills-- in other words, you want to increase disposable income. Directly, someone else's spending is your income; your spending is someone else's income. To return to the kind of employment we had before the crash, we need to get back to the kind of spending we had before the crash.

Here we get back to how consumers were maintaining spending levels in the pre-crash era: they could work up short-term debt, with relatively high interest rates (i.e. credit cards), but more importantly, relatively high payments. Then, if they had a house, and equity in the house, they could take out a second mortgage, refinancing that debt into long-term debt, lowering overall the payments they were making on their total debt. Then they had more disposable income, and could continue on with their spending habits-- and all that spending kept a lot of people employed.

Yes, we need to either keep current debt levels overall stable, or pay them down. But carrying most of that debt in short-term debt makes the payments higher-- which is why you're supposed to pay down your credit cards first if you're digging yourself out of a debt hole. In the current market, however, if you have a need to take on more debt (perhaps because you lost your job and it took you 3-4 months to find a new one, for example), you can only take on debt in the short term, and there's now way to roll that over to long term debt. Ideally, you should be able to roll that short-term debt you took on because of temporary crisis, and roll it over into long-term debt that you can pay down at a reasonable rate.

That process has broken down, for two reasons. First; a fair chunk of consumers don't have access to second mortgages, or other means of refinancing their current short term debt into long term debt, because they have nothing to borrow against anymore. Their mortgages are underwater; their cars are breaking down because they're making them last longer since they can't afford a new one. Second, the banks are being tighter with credit in the first place.

The Housing Bubble

Part of the reason the banks were giving out such easy credit was that yes, the Fed was keeping interest rates artificially low to try to inflate our way out of crash of the Internet Bubble. That started the rush to investment. There was a much bigger problem, however, and that problem was with the banks. They thought they had a fool-proof way of protecting themselves from the risk of default on that debt, particularly in the housing market. Since housing prices were 'never' going to go down, all they had to do was just foreclose on a house and sell it to make their money back. With all the complicated derivatives, where they would package a bunch of mortgages together, and then sell shares in the package-- and then, on top of that, bundle all those shares together, and then sell shares in in the bundle of shares of the bundle of mortgages. It was supposed to distribute the risk of any one of those mortgages defaulting in a way that lost money, as they knew inevitably some would.

This had a perverse effect on the market, though-- bankers, believing they had safeguarded themselves from the risk, started making loans to people who were more and more likely to default on that debt. The extension of this credit to the housing market created more demand. Speculative investors got involved; people who weren't buying houses because they were interested in living in them, but as investments they could 'flip' to make money. The infusion of credit and investment cash created a boom, and everyone wanted in on the deal.

Then the bankers added the timer that would eventually trigger the crash that inevitably came with speculation: the adjustable rate mortgage, which allowed them to offer loans with low initial payments that would adjust upwards later as interest rates climbed. They even went further than that, with the 3-year and 5 year ARM, where you paid a low, low payment for the first 3 or 5 years, and then the payment adjusted upwards. The ARM was supposed to let the banks themselves make money off of the speculative investment going on in the housing market-- the idea was that a house-flipper could buy a house or two and make the payments on the 3 or 5 year ARM, for which the bank could charge a little extra in terms of the interest they'd make in that period in other investments. Then the house flipper would sell the house, make their cut, and the bank would make it's cut, and everyone profited. Even if the flipper couldn't flip the house, the bank could just foreclose and at least make it's money bank. Add in the derivatives that were supposed to distribute that risk, and boom, a money making machine, sure never to fail (or so they thought).

The trouble was that they thought they had the risk thing under control, but forgot that speculative investment has peaks and trenches, as people sell off their investments to make a profit. And interest rates in a boom economy are going to go up to keep inflation reasonable. The ARMs ultimately made the market even more susceptible to market volatility; they were from the outset created to make it easier to invest in the housing market, after all. Eventually, because eventually there would be a peak in speculation, prices would decline. And interest rates would be up. Eventually, there was going to be a bunch of people with ARMs on houses they couldn't sell for the prices they were buying them at. Eventually, the pile of houses bought and paid for with those ARMs were going to go to foreclosure, and then the pile of those houses would depress housing values further as they went to market as foreclosures.

It went further than that, though. All of this boom economy investment started creating even further perverse incentives, the main incentive being to create more supply for more demand in this popular investment. People were buying into these investment schemes without really understanding what the risks were in the first place, because it was where more money was being made. Banks started extending credit almost blindly just to get more mortgages to put into more investment derivatives, sure that the derivative scheme would protect them from the risk. They started selling ARM loans to people who weren't reliable house-flippers, or people who didn't even intend to flip the house, but just couldn't afford a fixed-rate house payment. That created all the explosive fuel for when the ticking time bomb of the ARMs came up.

Eventually, savvy investors started to figure out that something was hinky in the housing market. They stopped buying all those derivatives, or at least avoided the ones with what they saw as the major risks. That started to stem the flow of investment money into the housing market. Demand for houses at the crazy-high prices speculation had driven them to start to dry up as the investment money backed off. More people were stuck holding their houses when the 3 and 5 year ARMs came to the higher payment; more people couldn't make those payments, and so more foreclosures happened. This was a feedback loop; more foreclosures meant more supply on the housing market, but there wasn't sufficient demand at the going prices anyway. Prices dropped. Banks started losing money. And the time bomb went off, faster than anyone reckoned because in the modern market, we have computers to do our math for us, and to automate trading in just about every investment imaginable. The computers did the math quick, and started abandoning investment positions in housing just as quickly, which lead to a rapid, massive destruction of wealth. The time bomb went off. Housing prices crashed, and the banks lost a lot of money-- their balance sheets caved.


Current Market

Now, banks aren't as ready to give credit as they were during the boom years. They do more research into the people they're lending to, which raises the cost of making the loan in the first place. They're not only tighter with whom they lend to, they're more cautious then they were before the derivatives scheme lead to them expanding who and what made a good loan. This is particularly true in the housing market, because the housing market still hasn't really hit bottom.

There are more houses going to foreclosure; demand is still low, because barely anyone has the money to make an old fashioned fixed-rate loan with a downpayment. The banks don't want to get caught in loans that are going to go underwater as soon as they're made. They want more in down payments, so even if the house's value further erodes, they can still make money if they have to foreclose. Few people have that kind of money for a down payment, because no one has the disposable income. If they have a house, about 1/5 to a 1/4 of all mortgages are underwater, so they likely can't sell it and make enough to pay off the mortgage, much less sell it and have enough left over to make a down payment on a new house. Even those who aren't underwater might not be able to sell their house for enough to have a good down payment. So they're not selling, and that means they're also not buying. Even those who aren't underwater are making do with what they have, because they figure what they can get for their house in the current market isn't worth what they paid for it, and they don't want to eat that loss. So the foreclosures keep coming due to high unemployment and people defaulting on debt, and no one is buying. That is a pretty clear recipe for further declining prices, and so it becomes a feed back loop.

This is bad both for your average entrepreneur and your average consumer.

It's bad for the entrepreneur because your average entrepreneur is your average consumer, only a little more financially stable, and with a business idea. They get those small business loans to start new businesses because they have good credit, and some sort of collateral, something the banks can sell if the business idea fails and they can't make good on the loan. Your average consumer's biggest piece of collateral is their home, because it's the most expensive thing they own that can be resold. This is true of your average entrepreneur as well. So if the banks aren't making loans against housing because the housing market only has bad news coming for it, they're not going to make small business loans against the collateral of someone's house, even if they own the house outright or have substantial equity in the home. If they do, they're going to adjust the rate of the loan upward based on how much they think the home is going to decline. So unless potential entrepreneurs can attract venture capital from someone other than the bank, no new business ventures for them, and ultimately not enough shiny new jobs for the economy. The worse news is that investors are playing for safety rather then risk these days, because opening new markets when consumers have insufficient disposable income to support the growth of that new market is an even riskier bet. Even in boom years, the truth is that most new business ventures fail; it's why collateral is so important.

More, just your average consumer can't refinance their debt. Effectively, they have no equity in their homes. So the payments they make on their current debt remain pretty fixed, and so there's no way for them to gain more disposable income. No change in disposable income means no increase in spending, meaning no shiny new durable goods, or shiny new jobs to match the rate of population growth, not to mention a return to the workforce for people who have been out of a job for a long time. High unemployment depresses wages, meaning that the consumer has even less disposable income.

Stabalizing the Housing Market

So, what can the Fed do about all of that? How can the Fed help lower debt payments and increase disposable income?

The best tool the Fed has for that would be something we could call QE3, where instead of targeting the 2-5 year range, they were targeting long term debt, say in the 7-30 year range. That would significantly reduce debt payments on long term debt, increasing disposable income as consumers refinanced. Lowering the long term interest rates would also stimulate the housing market, which would bring back rising prices, and start restoring equity rather than sapping it with falling prices. More equity would mean more refinancing, more refinancing would mean more disposable income. More disposable income would mean more spending, and eventually, more buying of homes as part of that spending.

Yes, yes, mortgage rates are lower then they've ever been, and keeping them artificially low is part of how we got into this mess in the first place, helping to create the housing bubble. But here is why I laid out the entirety of the housing mess in the first place: the trouble with the housing bubble was the way the derivatives and ARMs correlated risk into one big pocket and put a timer on it. There would have been a natural bubble, yes-- but the bursting of this bubble was far more destructive than a natural investment bubble because of the derivatives, ARMs, subprime lending, etc. meant that so much more speculative cash was in the market in the first place.

After the crash, it will be some time before we look at housing the way we did before; hopefully we will never do so again, but certainly not within the next decade or two. Which begs the question: how should we look at housing? The current market looks at housing as almost the opposite of the boom-years; housing is in terminal decline, on it's way to some sort of asymptotic bottom, for as long as anyone can reasonably predict, beyond a long term projection that eventually housing will come back. The view that housing prices will always go down is as dysfunctional as the view that they will always go up.

What a natural housing market should look like is like any other market-- peaks, when periods of speculative investment drive bubbles, and valleys, when those bubbles burst. Bottoms are reached when savvy investors start to realize that market aversion to a particular investment are irrational, based more on irrational motives that have nothing to do with the value of a particular investment. If housing is just like any other commodity, then eventually it needs to hit bottom. That very candidly describes the housing market these days.

The trouble is that until the housing market hits bottom, employment will be stalled out, as durable goods sales will continue to be anemic due to low disposable income levels for consumers, and most entrepreneurs have no access to the equity they have in their homes (still their largest asset) to start new businesses; most consumers have no access to the equity in their homes (again, they're largest asset), and so cannot refinance debt to increase consumer spending. Housing prices will continue to fall, however, so long as the current pattern of unemployment remains; we are in a feed back loop here. Prices in a central asset class are in decline, meaning no one can access the equity in the asset class in decline, meaning they can not refinance debt against that asset, leading to a decline in disposable income, leading to further unemployment, in turn leading to further defaults on debt in that asset class, leading to further decline in prices in that central asset class.

What we want is to stabilize housing prices, so that those entrepreneurs, and consumers in general, can access equity in their homes (again, their largest asset). In the long term, we want to do our best to keep housing prices stable, so that we do not trigger the feedback loop we're currently in. Currently, prices are in decline. We have a tool we know will work to increase prices: artificial lowering of interest rates, which will lower mortgage rates and work to encourage refinancing in the housing sector, and ultimately towards raising prices. Responsible use would be to use that tool to counter the price erosion in the central asset class, and then to cease using that tool when the market stabilizes, in order to keep the market stable vs. inflation. Further, to increase stability, we need to discourage speculative investment in that central asset class through regulation, to head off the bubble such speculative investment brings. So-- tight regulation of derivatives, tight regulation of investment tools like ARMs meant to aid the speculator turn a fast buck.

That's all stuff in the playbook, especially after the financial reforms of this year. The barrier is oddly political, but not Dem/Republican political, or at least not in the traditional sense. There are reasons on both side of the aisle to criticize the Fed, most of which come down to distrust of government or distrust of business in general, or both.

It's political in the sense that the Fed itself is a political football, and if Bernanke makes the call that Greenspan did and stimulates the housing economy, then the Fed is going to get drawn into a big ass political shit storm. Politically, it makes no difference that when Greenspan did it, he was stimulating an area of the economy that was fairly stable in order to try to counterbalance the fall off in the tech sector, and if Bernanke was to try, he'd be doing it to try to fix a portion of the economy that is actually broken. So every politician who wants to be seen hating on the Fed, just because it's popular politics with people who have no real clue about monetary policy in the first place but distrust the government on principle will hogpile on such an action. They'll be given plenty of ammo by those who espouse a belief in a 'fixed' or 'hard' currency, namely bankers who have vested interest in keeping the inflation rate anemically low.