Electronic Journal, Vol. 3, No. 4, August 2009

Appendix 3

America's Housing Market

America's booming housing market, and the government-sponsored agencies that are financing it, may be the source of nasty economic problems ahead

House prices are notoriously cyclical. So it is fair to assume that the boom currently being experienced by America's housing market will not last forever. When the market does turn down, it will have the usual dampening effect on economic growth. In this cycle, however, there may be even more to worry about. A reversal in the housing market could have serious implications for the institutions whose lending has fuelled the boom. These include government-"sponsored" mortgage agencies such as Fannie Mae (the Federal National Mortgage Association), Freddie Mac (the Federal Home Loan Mortgage Corporation) and the Federal Home Loan bank system, which is mutually owned by thrifts. These institutions are increasingly important to the health of America's entire financial system.

The agencies have been increasing their lending at a 20% annual rate in the past couple of years, as, to rather less attention, has the Federal Home Loan system. The federal mortgage agencies already have combined debts of $1.4 trillion.

The financial markets may be allowing this to happen only because they believe, with some justification, that if things go wrong, the government will come to the rescue. Housing is a political minefield. Fannie and Freddie were fighting off complaints that they were lending too little, particularly to the poor and to ethnic minorities.

Nonetheless, it is the ballooning balance sheets, and the potential liabilities for the taxpayer, that are the most urgent focus of attention. Although they started life as fully public bodies - Fannie Mae in 1938, Freddie Mac in 1970 - they have since moved into a twilight zone between the public and private sectors. Shares in both are listed on the New York Stock Exchange. Both say they are genuinely private companies, which do not receive a penny from the government. Indeed, they are among the 50 most profitable American companies.

Yet they also enjoy benefits not available to any truly private firm, such as exemption from state and local taxes. They face less testing capital requirements than their private-sector rivals, allowing them to load on much higher levels of borrowing. Fannie and Freddie have roughly $32 of debt for each dollar of capital, compared with $11.50 of debt per dollar at large banks. Their implicit government guarantees allow them to borrow cheaply. And they have an emergency credit-line from the Treasury of $8.5 billion (so far unused). A third agency, the Government National Mortgage Association, known as Ginnie Mae, has an explicit guarantee, but is a much smaller organisation.

In 1996, various official reports looking at the case for a complete privatisation of Fannie and Freddie concluded that its quasi-public status represented a subsidy worth around $6 billion a year. According to the reports, as much as one-third of the subsidy is not passed on to mortgagees. Instead, it goes to shareholders and employees. Recently, Fannie's and Freddie's return on equity has averaged 24%, compared with 15-17% for private banks and securities firms. And pay is way above public-sector (and indeed most private-sector) rates.

At first, the federal mortgage agencies provided useful liquidity, making it easier for people to get a home loan. In the 1970s and 1980s they led the development of asset-backed securities markets, by selling bundles of mortgages, something none of America's then small mortgage banks could have dreamed of doing. Now, though, the financial markets are large and sophisticated enough to do without a federal helping hand.

So Fannie and Freddie may be doing more harm than good. They make mortgages slightly cheaper, while mostly stifling truly private competition (though currently they are making it easier for start-up Internet lenders to take on the established banks, prompting the banks to lobby harder against them). And they are expanding their range of activities. They are moving into "sub-prime" lending to less creditworthy borrowers. Some of the firms in that market reckon that the agencies' recent crusade against "predatory lending" in these markets is merely a figleaf to cover up their own predatory swoop.

A recent study by the American Enterprise Institute says that Fannie and Freddie are on course to "nationalise" the residential-mortgage market. Bert Ely, a co-author, reckons that their profit goals may lead them to expand into "jumbo" mortgages, above their current lending ceiling for individual mortgage loans, and even into commercial mortgages and small-business loans.

There are further reasons to worry. Fannie and Freddie's debt and securities are exempt from regulations that limit banks' exposure to the securities of any single private company. Currently, bank-held federal-agency securities and debt amount to one-third of total bank capital - a highly concentrated risk.

Fannie and Freddie may have fuelled an unsustainable credit bubble. The expansion of their balance sheets in the past two years represents massive credit-creation. Doug Noland of David Tice, a fund-management firm, reckons that their purchases of mortgage-backed securities during the financial crisis in autumn 1998 bailed out many troubled financial firms. Their continued expansion since then has pumped liquidity into the system when the Federal Reserve was trying to reduce it.

Precisely what their role has been is hard to measure, not least because they have been big participants in the less transparent corners of the derivatives markets. Nobody suggests the agencies are in any immediate danger. Fannie points out that defaults total only three cents for every $100 it lends. But, since they expanded so fast, the quality of their risk management has not been tested by a market downturn. Ominously, during the last housing bust in the 1980s, Fannie became technically insolvent, though regulators allowed it to "grow out of its difficulties".

The markets may be waking up to the risks. Ironically, the turning-point came earlier this year, when it was suggested that, as the supply of Treasury bonds dwindles thanks to the federal government's surplus, mortgage-agency debt could replace them as the benchmark used for pricing other fixed-income securities. Treasuries are guaranteed by the federal government, whereas Fannie's and Freddie's debt is not, at least in theory. Proposals for reform fall into two broad camps. One is to try to rein in the agencies, by keeping them to their narrow lending remit and imposing tougher capital requirements. The other, cleaner, approach would be to privatise them, so that the markets are left in no doubt that their debt carries no government guarantee, implicit or explicit. There is an encouraging precedent: in 1997 Sallie Mae, the student loans agency, was privatised by separating its government-guaranteed loans and debts from its future, non-guaranteed, activities. Expect Fannie and Freddie to pull all their influential political strings to stop it happening to them.

* "Nationalising Mortgage Risk. The Growth of Fannie Mae and Freddie Mac". By Peter Wallison and Bert Ely, AEI,2000

The Business Cycle Lives Again

SAMUEL BRITTAN, ECONOMIC VIEWPOINT

The US recession is more deep-seated than central bankers admit - but it may have benign side-effects in Europe

The Federal Reserve's emergency interest rate cut of January 3 was almost certainly triggered by financial indicators. There have been rumours about particular financial institutions but the widening of corporate bond spreads has been a fact, as has been the sharp, but perhaps temporary, narrowing since Alan Greenspan, Fed chairman, acted.

As for the real economy, it is no longer a question of when the US recession will begin but how long it will last and how far it will go. Private sector forecasters predict a drop in gross domestic product of about 0,5 per cent at an annualised rate in the first quarter of this year. But I am less sanguine about the sharp rebound most of them expect soon afterwards.

It helps, however, to look at the immediate data in historical perspective. In the depressed 1930s two views of the business cycle contended among economists. According to Keynes the trouble was underinvestment. The opposite, so-called "Austrian" point of view saw the trouble in overinvestment during the boom phase. (The name "Austrian" was a partial misnomer as the bastion of this theory was the London School of Economics.)

In any case, the exponents of that theory were dealt a body blow by their bad timing. During one of the worst depressions in modern history, a theory that stressed overinvestment did not stand an earthly chance. By the end of the 1930s, even most economists at the LSE had gone over to Keynes.

But a theory that may be inappropriate for the time it is put forward may have a lot to tell us at other periods.

The vigorous booms in the US in the last few years of the 20th century, and its recent crumbling, have the trappings of an Austrian-type cycle.

As a minority of skeptics has been pointing out for some time, there has been overinvestment in the US. It is not only stock market prices that have been too high. There has also been excess physical investment. It would be surprising if there were no excess capacity to work off.

The US readjustment could indeed be more difficult than that predicted by the Austrian theory. According to that theory, the investment boom is made possible by abnormally high domestic savings. But in the recent US boom - and, for that matter, in its weaker copy in the UK - there has been no squeeze at all on consumption, which has risen vigorously in the past five years. The savings to finance US investment have come partly from large budget surpluses, which count as savings in national income arithmetic, and also from a current payments deficit financed by inward investment.

Indeed, US personal savings have virtually disappeared. Because of the "wealth effect" generated by rising asset prices, Americans have felt that they could prudently consume more than they earned without eating into their financial resources. But once the stock exchange euphoria comes to an end the wealth effect disappears and people return to their normal saving habits.

Thus the US investment adjustment looks like being accompanied by a squeeze on consumer spending as well. The two forces would then have their usual multiplier effects on each other and on the economy. One mitigating factor is that real property values have held up better than equity prices, although if the recession continues this support could weaken. As it is, the recession is likely to be more obstinate than the optimistic central bankers' statements about a mere slowdown to 2,5 per cent growth this year.

What, then, should be the policy response? Clearly, to act promptly on signs of real weakening in the US economy rather than on prophecies of doom. But what should be the mix between monetary and fiscal stimulation? A benefit of further monetary relaxation is that it acts more quickly.

The offsetting danger of sharp interest rate cuts is that they could postpone the liquidation of the excesses of the recent boom and could even reinforce the idea -specifically disowned by Mr. Greenspan - that the Fed has the duty of supporting the equity market.

The case for acting on the fiscal front is that tax cuts have a more direct effect on consumption. But I cannot help being amused by the rush of Republican policy advisers, who previously proclaimed the utmost skepticism both about fiscal policy and about fine-tuning, to say that the prospective tax cuts are urgently needed to fight recession. In this they will be joined by Democrats who do not want to be accused of pushing the economy into a slump.

I have a -lurking suspicion that the structural budget surplus is exaggerated by recent estimates and will melt away when economic cold winds force a reassessment of the arithmetic - as they did in Britain in the early 1990s and could do again. And tax cuts are less likely to stimulate spending if consumers suspect that they cannot be afforded in the long run and ultimately will have to be reversed.

How about the overseas impact? A US recession normally has its severest and earliest effects on the Pacific area and Latin America. But in Europe there may even be some benign aspects, at least in the early stages. Were it not for the cold wind from across the Atlantic there would in fact be a case for an increase in the UK's base rates. Domestic demand is still growing vigorously: the payments deficit is rising; and skill shortages head the list of business complaints.

The slowdown in UK growth at the end of last year is deceptive. As the National Institute of Economic and Social Research has pointed out, the economy has been "depressed by the effects of the rail stoppages and weak output in the oil industry. This does not indicate a general slowdown and suggests the (Bank of England) was right not to reduce interest rates".

By encouraging the dollar to fall, further US interest rate cuts would relieve the worries of European policymakers who claim that the euro is undervalued. Thus even the European Central Bank might at last stop worrying about inflation and move towards stimulus. If a weaker dollar means a stronger euro, UK manufacturing will benefit and the UK economy will become better balanced.

A prolonged US recession would be a different story. It would be likely to have a bigger effect on Europe through confidence and financial effects than conventional forecasting models, which focus on visible trade, suppose. But it is one thing to foresee a danger and quite another to act prematurely on the assumption that it has already occurred - as those most stridently clamouring for UK interest rate cuts need to remember.

Wages in Recession

An intrepid economist ventures into the real world to investigate—and finds conventional explanations wanting

Economists dislike talking to people. They prefer a more "scientific" approach to research, such as number-crunching or abstract theorising. But that can be a weakness, as a new book by Truman Bewley, an economist at Yale University, makes clear. In "Why Wages Don't Fall During A Recession", published by Harvard University Press, he tackles one of the oldest, and most controversial, puzzles in economics: why nominal wages rarely fall (and real wages do not fall enough) when unemployment is high. But he does so in a novel way, through interviews with over 300 businessmen, union leaders, job recruiters and unemployment counsellors in the north-eastern United States during the early 1990s recession.

Explanations for why wages are sticky abound, but they are often unconvincing. Neoclassical economists, who have a starry-eyed faith in the efficiency of markets, think wage rigidity is an illusion. In their view, workers quit their jobs when pay starts to fall in a downturn. This stops wages falling much and makes them appear inflexible. But their theory implies that unemployment in a recession is voluntary - a view at which reasonable people might rightly scoff.

Keynesians, who accept that markets are often imperfect, think wages are sticky, but cannot agree why. Some blame unions or established employees ("insiders") for blocking pay cuts. Keynes himself thought that workers were so concerned about their wages relative to those at other firms that no company dared to cut pay. Others argue that firms pay high "efficiency wages" in order to make the threat of job loss more costly for workers and so spur them to work harder. (Wages might still fall in a recession, though, since workers are more afraid of not finding another job when unemployment rises.) Still others claim that firms implicitly insure workers against a fall in income in exchange for lower long-term average wages. And so on.

One or more of these theories may be true. Or perhaps none is. Economists do not really know, because the labour-market data with which they test their theories is inadequate. So Mr Bewley tried asking people who should be in the know. He is aware of the pitfalls: interviewees may be unrepresentative, lie or obfuscate. They may not understand their own motives. Still, since economists are ultimately trying to describe human behaviour, meeting real people ought sometimes to help.

Mr Bewley finds scant evidence to support the various wage-stickiness theories. His interviewees say unions are not to blame for wage rigidity: few American firms are unionised, and in those where unions are important "the first line of resistance to pay reduction was almost always management." Nor are "insiders" blocking pay cuts: few non-union workers bargain over wages with their employers, and no employer remarked on a sharp division of opinion over layoffs among workers, who more typically thought that pay cuts would not save jobs.

Keynes's theory gets short shrift too. Mr. Bewley finds that, although pay rates across non-union companies are connected by supply and demand, firms still have plenty of latitude in setting pay because workers have scant knowledge of pay rates elsewhere. Nor is much credence given to the efficiency-wage model. "People do work harder during a recession because they are concerned about their jobs ...however, the logic does not imply that companies pay well for reasons of discipline. They do so in order to attract and retain employees," says a typical personnel officer in a middling manufacturer. The implicit insurance model fares little better. Employers do not think such a bargain exists and believe that it would be unenforceable in any case, since long-term pay is determined by competitive conditions.

All in a day's work

Why, then, are wages sticky? Mr. Bewley concludes that employers resist pay cuts largely because the savings from lower wages are usually outweighed by the cost of denting workers' morale: pay cuts hit workers' standard of living and lower their self-esteem. Falling morale raises staff turnover and reduces productivity. Cheerier workers are more productive workers, not only because they work better, but also because they identify more closely with the company's interests. This last point is crucial. Mr. Bewley argues that monitoring workers' performance is usually so tricky that firms rarely rely on coercion and financial carrots alone as motivators. In particular, high morale fosters teamwork and information-sharing, which are otherwise difficult to encourage.

Firms typically prefer layoffs to pay cuts because they harm morale less, says Mr Bewley. Pay cuts hurt everybody and can cause festering resentment; layoffs hit morale only for a while, since the aggrieved have, after all, left. And whereas a generalized pay cut might make the best workers leave, and a selective one damage morale because it is seen as unfair, firms can often lay off their least competent staff.

Mr. Bewley's theory has some interesting implications. Pay cuts are more likely at firms whose demand for labour is price-sensitive, such as those in highly competitive industries. Since many markets are becoming more competitive, wages may also be getting more flexible - and unemployment may rise less in recessions. Wages are also likely to be less rigid in short-term jobs, where workers do not become attached to their firm. On the other hand, since more workers now do jobs that are hard to monitor, or in which they need to co-operate, share information, be creative or be nice to customers, wages may become stickier.

Mr. Bewley's book is not the last word on sticky wages. Some of his findings are probably specific to the north-eastern United States in the early 1990s. But his theory has a ring of truth to it. And if his example spurs other economists to venture out of their ivory towers, so much the better.

The Relations of the EU with the IMF

IMF by Robert Chote, Economics Editor

“Critics contend that the IMF was slow to pick up problems in its regular consultations with governments”.

The IMF is being urged to focus its surveillance efforts and to concentrate on its core areas of expertise.

The IMF performs surveillance of economic policies. The quality of this surveillance has been called into question by the financial crises that have swept emerging markets in the past 2,5 years. Critics of the EU contend that the IMF was slow to pick up problems in its regular consultations with member governments and that it could have done more to prevent the crises erupting.

In the light of this criticism the IMF's executive board commissioned three outside experts to carry out a review of the policy surveillance process.

Their report urged the Fund to focus its surveillance efforts. The institution should resist pressure to expand its surveillance activities into structural policies, concentrating instead on its core areas of expertise: exchange rate and other macroeconomic policies, the financial sector and capital account.

This is difficult given the enthusiasm of many policy-makers for using the IMF to police adherence to international standards or codes of good conduct. But "outside the Fund's core areas monitoring international standards should to the maximum extent possible be delegated to other international institutions or associations with the necessary expertise. Particular attention should be paid to any vulnerabilities which show up in individual economies.

The Fund was also encouraged to regard surveillance of national policies as a continuous process.

The euro-zone should be treated as a single unit for surveillance purposes. This is likely to prove controversial among European governments, many of whom feel that surveillance of the euro-zone should be carried out mostly by EU institutions themselves.

Surveillance of the largest economies has always been difficult. Financial markets have plenty of competing analyses on which they can base their judgments.

The study of the UN suggests that the surveillance of the US, Japan and the euro-zone economies should thus focus more on the international aspects of policy, notably the knock-on effect that policies in these economies have on the rest of the world. This partly reflects the experience of the recent financial crises, which were explained in part by the movement of the dollar/yen exchange rate.

Surveillance is not simply a question of analysis by the IMF staff and management. Another important issue is the way this analysis is considered and reflected upon by the IMF board, which comprises political representatives of IMF member countries (mostly organized into constituencies).

Each committee would deal with surveillance of a region corresponding to one of the Fund's area departments. The committees would, however, include directors representing countries both inside and outside the region concerned.

Appendix 4