July 2006 Archives

First the nonsense. Mark Thoma quotes a Financial Times piece by Rep. Jim Kolbe. For the sake of brevity, the last line from Kolbe says it all.

Far more people would confront the need to rein in entitlements if they understood how they are putting our foreign aid budget in a straitjacket.

By entitlements, Kolbe is speaking broadly to include Social Security, Medicare, etc. To which Mark responds,

I don't have time to deal with this properly, so hopefully comments or other bloggers can put this into it's proper place, but the amount of foreign aid we give relative to the size of the budget, spending on the war, and so on, is miniscule, low among developed countries on a per capita basis (this says 27 billion in 2004).

Indeed. When I read Mark's post, I couldn't help but wonder just how I would properly deal with such a statement. Foreign aid is often smaller than the forecast error in the budget. True, foreign aid would be one among many programs fighting it out for the remaining funds if there were broad cuts in discretionary programs. But my assessment of the situation is that there is a substantial enough lobby to prevent any serious reduction in aid. There are other, larger, more promising targets for the budget axe. Now, might there be some political reason for setting up a false tradeoff between foreign aid and Social Security? Of course. One doesn't have to be all that cynical to see that. There are always political reasons for framing the rhetoric of budget priorities. So take that and see where you end up.

By the way, I'm no huge fan of the current system of foreign aid. What we do spend is often used less than effectively. That doesn't change my opinion of Kolbe's odd comparison.

So that's the nonsense. PGL at Angry Bear chimes in as well, and in a comment to that post he offers up some sense about Social Security. For context, the comments at AB went in the direction of the "trust fund" as often happens when Social Security is the topic. PGL writes,

On this no trust fund argument, consider this analogy. A 53-year old worker has accumulated funds in a private retirement account to which he'll continue to add savings draw from his salry for the next 12 years. In 2018 he retires and wishes to draw funds from his account from 2019 onwards. Imagine his reaction if he were told that his account weren't really there. That's the rightwing argument. Something tells me that this 53-year old would not accept it in the least.

That is a nice illustration to make the point that the trust fund represents a commitment to play by the rules of the game (but see below). And that is precisely how I see the trust fund. It is an accounting device that represents the promise to follow the law as currently written. The accounting device (whether a ledger sheet or a file cabinet full of bonds) is not the important thing. The promise is. As I said a year-and-a-half ago:

We need to be careful about what we mean when we discuss (or imply the possibility of) default lest we fall into rhetorical traps. The "worthless IOU" argument is itself worthless. There are undoubtedly other cases where it has been used to get the attention of the reader and then been cast aside when it has served its purpose.

My opinion on that has not changed.

To elaborate briefly on PGL's point, the government wouldn't tell the holder of a private account that his account no longer exists. Rather, they could allow inflation to eat its purchasing power away, or they could raise the taxes on investment income. The rules of the game can be changed in many ways--some ways are easier and/or more visible than others, and that should not be forgotten. But the basic thrust of his comment is on the mark.

And that brings us back full circle to the Kolbe article about "entitlements" in general and the trade-offs that they imply for present and future Congresses. Entitlements are, in effect, promises. People assumed that those promises would be kept when they made decisions such as how much to save for retirement. Just remember that when people plan how much to contribute to their private retirement funds, they are also making assumptions about future tax rates and inflation rates. However, I'm not sure that we treat those assumptions like promises--we know that tax rates and inflation rates are too fluid to project out 30 years. That is a distinction worth remembering.

Hal Varian compares the international financial system to a ballroom dance. (NY Times)

The international financial system is like a 19th-century ballroom dance. The central bankers lead with an interest rate adjustment. Their partners, the global investors, watch them closely, trying to anticipate their every move. In the background, the waiters carry their trays of imports and exports slowly back and forth, taking their cues from the pace set by the dancers in the center of the ballroom.

It's worth your time to read the whole article if you're new to the topic of global interest rates. Mostly, he summarizes what readers of the financial and macroeconomic blogs already know. He concludes...

The current interest rate increases are an attempt to slow the economy to avoid inflation. But over the next decade, we may be forced to raise interest rates simply to attract foreign lending to finance our budget deficit.

Such high rates would damp economic growth, putting more pressure on the Fed to return to the low-interest, easy-money policy we have seen in the past few years.

Such a policy runs the risk of stimulating inflation. The easy-money policies in the past few years have had a surprisingly small impact on wages, in part because of the threat of jobs moving to countries with lower labor costs. But if the dollar fell far enough, foreign labor would no longer be a bargain, giving domestic workers more leverage in wage negotiations.

In this chain of events, an inflationary spiral would become a real possibility, making the cost of a stumble on policy higher. Let us hope central bankers can keep dancing in step as they move interest rates back to normal levels.

These op-ed columns are a difficult way to educate the public on something with as many twists and turns as international finance. I enjoy Varian's writing, and wish he had more space to elaborate. But comparing central banking to ballroom dancing does get across a subtle point to the Times' readers. That point is that in a global economy, no central banker can do things entirely as he pleases without taking into account the other bankers.

UPDATE: Mark Thoma has some fun with Varian's piece.

There is a new version of the Parker Brothers classic, "Monopoly", that uses a mock debit card. (Wired article) Visa scores a nice product placement in the process.

I'll admit it's a cute gimmick, but that's about it as far as I'm concerned. I do not think it will speed up game play. Since "Monopoly" can be a rather slow game anyway, I would not think that this represents an improvement. As I sit here, I've been thinking through what it might be like to play the game with a debit card. I can see potential advantages and disadvantages, but on balance I'd see more on the downside.

Now, if they could only make the game board electronic with little LEDs to indicate where the houses and hotels are so that you didn't have to worry about bumping the board and sending them flying... now that would be worth buying.

The NY Times has a good article on the re-fi boom.

It is the latest twist in the gravity-defying world of the high housing prices and exotic low-rate mortgages: As monthly payments on adjustable-rate mortgages are starting to balloon, many Americans have found a way to put off the day of reckoning.

...

When that happens, for instance, a typical borrower with a $200,000 A.R.M. could see his monthly payments increase nearly 25 percent when the A.R.M. adjusts from 4.5 percent to 6.5 percent. In total dollars, that is an increase from $1,013 a month to $1,254.

Yet instead of paying more now, many borrowers are refinancing into their second or third adjustable-rate mortgage, loan data indicate and industry experts confirm.

So far, the number of borrowers refinancing this way is relatively small — several hundred thousand in the estimate of the credit ratings firm Fitch Ratings — but mortgage industry officials and analysts expect the numbers will surge next year. In doing so, these borrowers are pushing out any eventual shock of higher payments by another two or three years, if not longer.

“They get another two- or three-year hybrid with a low introductory rate to keep payments down,” said Frank E. Nothaft, a vice president and chief economist at Freddie Mac, the mortgage buyer. “They’re trying to put it off forever, which is O.K. as long as interest rates are low. But when they start to spike, then it’s going to be more problematic.”

Obviously they are chasing after the low "teaser" rates that come with a new ARM, which, though higher than a year ago, are still reasonable. They'd just better hope that Bernanke does a good job of warding off inflation...and that their house continues to appreciate. Do you feel lucky? The article continues...

But the refinancing also represents a doubling-down on a bet that housing prices will continue to rise on the West and East Coasts and in other hot markets. If the value of the home falls closer to the amount of the loan, that could curb the ability to refinance, and may prompt the homeowner to either invest more in the home or to sell it.

Such would be the case if you had an interest only ARM and a high loan-to-value ratio.

With his new loan, his third adjustable-rate mortgage, Mr. Perry, a former technology project manager, cashed about $200,000 out of his home’s equity and is investing it into his four-year-old financial planning business. “I could have sold my house and made my family move,” said Mr. Perry, 42, who lives with his wife and a 3-year-old son in Danville, about 20 miles east of Oakland. “But I didn’t do that. I said, ‘Look, I want to start a new business,’ and this product allowed me to do that.”

He said he was taking on more risk than many of his clients would be willing to because he believes his business will continue to grow. After spending 15 years in the technology industry, which put him on the road constantly, Mr. Perry said that being self-employed allowed him to spend more time with his family, which he also expects to grow. As far as the house, he said: “I am not going to be here for 30 years. Why is it important to have a fixed mortgage?”

And who am I to fault a person for taking a risk. This strategy can pay off, and it is quite possible that the subject of the article is just the type of person who can really benefit from this. It all depends on a person's willingness to take on a risk and their fallback position if things don't work out as planned. That is a highly individual decision. I predict that these stories will be told with increasing frequency. Some will turn out better than others.

However, there is one piece of this story that the Times left out. I was about to write that they omitted the fees that go along with refinancing. But a new blog worth reading, Credit Slips, beat me to it. (Hat tip to Stephen Bainbridge for calling attention to this new site.)

The Times article does not emphasize how expensive this re-refinancing is. Closing costs and fees all get lumped back in to increase the outstanding balance. Keep in mind that these buyers couldn’t make market-based payments on the old, lower balance. The odds of making those payments on the new, higher balance are worse than those in any Las Vegas gambling parlor.

In the industry, these mortgages are called 2/28s. The numbers refer to the teaser period (the 2) and the real payout period with the higher-than-market interest rates (the 28). How can the “2” be profitable for the lender, if the debtor re-fi’s the loan without paying the high 28 period? Many of these loans carry a pre-payment penalty, along with up-front fees and closing costs that make them instantly profitable. Even if the debtor refi’s immediately, the amount paid off includes all these costs, making the effective interest rate for the “2” ten or twenty times higher than the stated interest rate. In the 2/28 game, the lender nearly always wins.

Could re-refinancing be the knife that will cleave what is left of the middle class? There will be those who have fixed-rate mortgages, who pay off their homes, and who have something for retirement or savings if a catastrophe hits. And then there will be those who live in houses, paying high rent, always vulnerable to rate hikes, flat real estate markets, job layoffs, etc. That last group will nominally be called "homeowners" just like the first, but they won't really be. They will play the 2/28 game until they go bust.

In Vegas, the odds always favor the house. In banking, transaction costs can make it difficult (though not impossible) to get free money. Those prepayment penalties can be steep. So shop around for the lowest fee structure. With good credit, there are probably still some to be had. However, many of these people do have less than perfect credit. They will end up paying the fees. While I stop short of condemning these types of mortgages, it suffices to say that one has to weigh the risks carefully, and check the fee structure on the loan. Such loans do increase the housing opportunities for many people, and many will use them to their long-run advantage. However, the bank needs its cut, and someone, somewhere will pay the freight.

Or, as economists are fond of saying, "TANSTAAFL!"

I have not vanished from the blogosphere! I have, however, taken some much needed time to work on some research. I'm also working on a major change to my department's web pages. Hopefully those will be unveiled in a few weeks (the process is not quite done).

I'm working on a longer post about monetary policy and the Bernanke testimony. But I just thought I'd chime in with a quick word about what I've read. Tim Duy gets it about right when he says today that he finds tracking the Fed to be maddening. There is no doubt that Fedwatching was a little easier a year or two ago, but those days of easy predictions may have spoiled us a bit. This is the real deal. The answers are not clear. Well-intentioned people can disagree over the appropriate policy. This sort of situation (not the no-brainer decisions of late 2004) is why I've always been fascinated by the Fed. I think I find it a little less maddening because all signs have been pointing to this for the better part of 2006. Even though the Greenspan era will be long remembered for increased transparency, we saw at the end of Greenspan's term that too much transparency can talk you into a rhetorical corner. Bernanke has, I am glad to see, tried to avoid that. That's not a knock on Greenspan. Bernanke is standing on the shoulders of a giant, and I believe he can learn from some of the things that his predecessor may have learned too late.

So I'm not surprised that Bernanke was not specific about the possibility of future rate increases, nor am I surprised at the way that the market is interpreting his comments. Indeed, if he had been more specific, I would be complaining that it could make his job harder in the future.

At any rate, I've been leaning towards expecting another increase and then probably a pause--after that it's back to being data dependent for the rest of the year. I wouldn't rule anything out past October. And I'm not sure I would trust any prediction that does rule out any specific possibilities that far out. I am not ready to call it "one and done." I still think it's "one, pause, re-evaluate..."

So, even though Bernanke's testimony did move markets, it didn't change much in my assessment. Whether the markets overreacted or simply caught up to where they should be is for another day. I expect a lot of additional discussion as the August meeting approaches.

More to come. I need to attend to some other things this evening, but I will be resuming a more normal blogging schedule. Your patience is appreciated.

He is an outstanding choice. He will fill the seat vacated by Roger Ferguson which expires in 2014. Governor Mark Olson recently announced his resignation which is effective today. Olson did not attend this week's meeting. Read the NY Times article on the Mishkin nomination. A Bernanke and Mishkin combination lends a lot of academic credibility to the Fed. I'm very pleased with the news.

Professor Mishkin, 55, has been a prolific author of books and articles about central banking and would add weight within the Fed to backers of "inflation targeting," a policy of basing decisions on explicit and publicly disclosed benchmarks for inflation.

On that issue, Professor Mishkin would be a close ally of Ben S. Bernanke, the new Fed chairman. Mr. Bernanke has been a champion of inflation targeting, an approach that his predecessor, Alan Greenspan, viewed as too rigid and that some Fed governors continue to oppose.

Professor Mishkin and Mr. Bernanke collaborated on a book and several articles about the issue, arguing that the strategy would make the Federal Reserve's decision-making more open and predictable.

...

Professor Mishkin is believed to be a political independent, and has had almost no involvement with Republican politics. Donald L. Kohn, whom Mr. Bush recently named as vice chairman of the Fed, is a political independent who was a senior staff official at the Fed before being named a Fed governor in 2002.