Fiscal stimulus: More needed?

February 1, 2009

The House has passed HR1 and the Senate is working on a counterpart fiscal stimulus bill. We will discuss HR1 for the sake of specificity and in the belief that the final law will be fairly similar to HR1.

The table below shows the Congressional Budget Office’s estimates of the spending increases and tax cuts under HR1. The government’s fiscal year ends on September 30, so the first period is the 8 months from now until the end of September. One of the major concerns about the program is the lag in ramping up the stimulus. Recall that the economy will be about $900 billion below trend in the middle of the year, but spending programs up to then will only pay out $107 billion and taxes will have been cut by $63 billion. The stimulus is much larger in the following 12 months, starting in the fall of this year, when spending will be up by $236 billion and taxes cut by $120 billion. Then in the following fiscal year, 2010 to 2011, the stimulus falls to roughly half its peak level. Effects in later years are tiny.

hr1table

 The spending increases under HR1 are wonderfully diversified. We had been concerned that the program would involve large amounts of spending in certain favored, narrow areas, and that the supply of the corresponding products would have bottlenecks. In that case, the direct employment effects would be smaller and the spending would have driven up the incomes of some lucky workers. But in 2009 and 2010, broadband gets only $250 million, school building repairs $9 billion, and health information technology $500 million, to mention three areas that the new administration had been singling out earlier as especially suitable. Though the spending side of the program has been widely criticized as diffuse, we see that characteristic as a virtue.

The biggest piece of the tax side of the program is a conventional tax rebate, similar to the one in the summer of 2008. Because it would be refundable-that is, it could result in a taxpayer receiving money back rather than paying less tax-the government accounts for it partly as spending (the refunds) and partly as reduced taxes. The total amount is $144 billion for 2009 and 2010. On the business side, speeding up depreciation and allowing earlier recovery of tax benefits from operating losses would result in a drop in tax collections of $90 billion, to be made up with higher collections in subsequent years-this is an interest-free loan program more than a tax cut.

Effects of fiscal stimulus

How much does real GDP respond to the two forms of fiscal stimulus, government purchases and tax cuts? The incoming Obama administration released the Romer-Bernstein study of fiscal stimulus to answer the question. The table below shows the main conclusions. When the government increases its purchases of output, say concrete for new bridge, GDP rises immediately by about the amount of the purchase (1.05 in the first quarter) and then rises to about 1.6 times the amount of the purchases. The calculation assumes that the flow of purchases remains higher for the whole 16-quarter period shown in the table. For tax cuts or other programs that give families more purchasing power, the immediate response is more like half the amount the government spends; the other half goes into savings. In both cases, the multipliers rise as time passes because of follow-on effects-increased spending by those influenced by the immediate effects.

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 Fiscal Multiplier Estimates from the Romer-Bernstein study of fiscal stimulus

The measurement of these multiplier effects is intensely controversial. Having followed this area of macroeconomics carefully for many years, we believe that both columns overstate the responses somewhat, especially in the case of tax cuts. All macro models agree that increases in government purchases increase real GDP. That multiplier is probably around one, we believe, but we would not rule out 1.5. Most macro models place the tax-cut multiplier quite a bit lower, and we agree. Here we are referring to tax cuts that hand families more purchasing power, such as the one n the summer of 2008. Later we discuss tax changes that give focused incentives for immediate spending, where the effect could be much larger.

Last summer, consumers enjoyed a moderate tax cut paid out to most people as an immediate rebate. The experience demonstrated that the federal government is capable of a speedy fiscal action, but it also showed that consumers don’t go out and spend rebate money when they receive it. Instead, just as the received theory of consumption predicts, consumers smooth the spending increase, reserving most of it for future consumption, by saving it or using it to pay down debt. It raises their standard of living more than their immediate spending. It’s good news that most Americans do not have their backs to the wall financially, but it makes an income- tax rebate ineffective as a stimulus concentrated at the time most needed. Rather, rebates result in consumption increases spread well into the future. We discussed John Taylor’s graphic analysis of the tdax cut in an earlier post.

Effect of Government Purchases

HR1’s focus on government purchases raises the natural question of the effect of purchases on total GDP. Does government spending stimulate other categories of spending, especially consumer spending? Or does government spending displace other categories, so GDP rises by less than the amount the government spends? What does research say about the left column in the table above? An earlier post addressed this question.

What could have been done

The most desirable time-concentrated stimulus would raise consumer spending during 2009 without changing it much in future years. The government lacks the power to compel consumers to spend more, so it must rely on a incentives. Britain has just cut its sales tax (VAT) by 2.5 percentage points for the next 13 months to provide a small incentive concentrated in the period when the recession is expected to be most severe.

An important article in the American Economic Review in September 1986 by James Poterba, Julio Rotemberg, and Lawrence Summers demonstrated the high potency of a sales-tax cut as a stimulus. They studied the reverse situation, where a big increase in the British sales tax caused a severe recession.

Because the U.S. lacks a national sales tax or VAT, the logistics of a temporary consumption subsidy would be a little more complicated. The Kotlikoff-Leamer proposal would operate through state sales taxes. All but a few small states have sales taxes-the exceptions are Alaska, Delaware, Montana, New Hampshire and Oregon. Under the plan, the federal government would buy out sales taxes for the period of the needed stimulus, say the year 2009. The states without sales taxes or with low sales taxes would receive comparable federal funds to cut other types of taxes. Sales tax revenue is currently $440 billion per year, so the proposal would cost around half of what the Obama administration appears to be planning to spend on stimulus.

The plan needs to take effect soon after it is announced. The announcement will cause consumers to defer purchases until the tax cut takes effect. Similarly, toward the end, they will accelerate purchases and then buy less after the sales tax resumes. Phasing in the resumption might be a good idea.

Critics of consumer subsidies point out that some consumer goods are imported, so the stimulus benefits the producing country, not the U.S. Often that country is said to be China, though Japan is also a major source because of its dominance of the world car market. Given that the U.S. has pledged to engage in joint stimulus with its major trading partners, including China, the stimulus to the import source countries is entirely appropriate. But imports of consumer goods are only 18 percent of consumer spending on goods (excluding services), so the leakage into import stimulus is not a major consideration anyway.

We feel that a temporary elimination or reduction in sales taxes would be an effective stimulus to consumer spending, concentrated in the period when it is needed most and phased out later. It should be part of the stimulus plan.

Tax cuts to reduce the cost of labor or improve incentives to work

If the objective of a stimulus is to lift employment, why not operate directly on that margin, by improving incentives? The Senate is considering a program called Making Work Pay (see the Brookings Institution evaluation) as part of its version of the stimulus bill. This program would buy out the first $500 of the payroll tax that all workers have to pay, even those who do not pay income tax. This program has a definite effect on the incentive to work for those without jobs and for those who are currently paying less than $500 in payroll tax (those earning less than about $8,000 per year), but for most workers, the $500 would be just like a standard tax cut, without any special incentive effect.

In a standard supply-and-demand diagram, with the pre-tax wage on the vertical axis, giving an improved incentive to workers shifts the supply curve to the right-people are willing to work more hours at a given pre-tax wage because the tax that they used to pay has been removed, the equivalent of an increase in the wage.  The market clears at a point down the demand curve, with higher employment. That is the hope of a plan to cut the wage tax paid by workers. Notice that the pre-tax wage as to fall to stimulate demand. If the wage is sticky, nothing happens-workers would like work harder, but that message does not get passed on to employers through a lower pre-tax wage. Thus another reason that Making Work Pay may not stimulate much job-creation is that the needed decline in pre-tax wages won’t occur.   

Why not overcome this problem by giving the incentive to the employer? The federal government has a completely straightforward way to do this, because it levies a 7.65 percent rate on employer payrolls for virtually all employment. The tax yields just under $500 billion per year. Elimination of the tax for the year 2009 would provide a substantial incentive to employment concentrated during the year. As with the temporary removal of sales taxes, both anticipation effects and ending effects would occur. See the Bils-Klenow proposal.

One problem with the employment stimulus is that the funds go in the first instance to the owners of businesses and not to consumers generally. Ownership is highly concentrated in the U.S., so the distribution of the immediate benefits is skewed. By contrast, a worker or consumer rebate can be directed to lower-income consumers because it is part of the income tax.

If the response of employment to the payroll tax cut were strong enough, its contribution to the incomes of workers might be enough to overcome the disadvantage of its business-subsidy character. If business hiring responded aggressively to the subsidy, profits would decline as business put more output on the market and the winners would be workers rather than owners. Everything turns on the strength of the employment effect. But, alas, the strength of the effect depends on one of the most unsettled issues in macroeconomics, the role of supply increases in raising the quantity of output produced in the short run. One line of thought treats this issue just as one would in a standard market, where an increase in supply raises the quantity sold by the principles of the standard supply-and-demand diagram of elementary economics. Another line believes that special principles operate in the short run that makes demand the controlling factor-an increase in supply has little effect on the quantity sold in the short run in this view. We are among the few economists who regard this issue as still open. Most are doctrinaire believers in one or the other view. We are sufficiently concerned about the potential validity of the demand-limiting view that we are reluctant to state with confidence that a supply-based stimulus such as the payroll-tax suspension would have a large effect on employment.

Will the economy need more stimulus after the current program goes into effect?

The answer seems obviously yes. Current forecasts were made with pretty good knowledge of the nature and magnitude of the Obama stimulus program and they say that the economy will be in deep recession through the middle of the year and below trend with excess unemployment for several more years. Further, from Tables 2 and 3, it is clear that the increases in purchases and increases in consumer purchasing power from the program, after applying the Romer-Bernstein multipliers, would have effects quite small in relation to the GDP shortfall of close to a trillion dollars a year.

Conclusions on stimulus

We foresee a mixture of stimulus policies for the coming year. Monetary policy can contribute by driving down mortgage and other interest rates. Income-tax rebates seem to have little support and would probably have relatively small effects within the year, with undesirable continuing effects in later years. We are enthusiastic about removing sales taxes and then brining them back gradually, to stimulate immediate consumptions spending. We are not sure that an employment stimulus from a reduced business payroll tax would raise employment enough to be a contender as a stimulus. Thus the sales-tax buyout seems to be the best way to spend the bulk of future stimulus dollars.

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The recession finally hits plant and equipment

January 31, 2009

We had pointed out earlier that, despite all the downdrafts in the economy and a recession that started at the end of 2007, real plant and equipment spending was still on its normal growth path as of the third quarter of 2008. The first estimates for the fourth quarter show plant and equipment below trend. Here is our decomposition of the changes in the composition of real GDP since the first quarter of 2006:

   
  Excess over trend (billions of dollars)
Consumer durables -181
Consumer non-durables and services -273
Residential construction -371
Plant and equipment -68
Inventories -52
Imports 277
Exports 182
Government -7
Real GDP (sum) -493

The collapse of residential construction and of consumption is still the main negative effect visible in the breakdown of real GDP.  A decline in plant and equipment investment, all in the fourth quarter, is a new negative factor, as is the decline in inventory investment from its normal level. On the other hand, both parts of international trade are still remarkably favorable–over the course of the recession, imports have fallen $277 billion relative to trend, relieving the negative effect that high imports had in the past. And exports are $182 billion above trend. Real GDP is now almost half a trillion dollars below trend.

The consensus among forecasters is that real GDP will decline by about 1.5 percent to a trough in the middle of this year (3 percent annual decline on average over the first and second quarters), which would place GDP about $900 billion below trend.


What to do about Fannie Mae and Freddie Mac?

January 28, 2009

 

  Here are our recommendations. A discussion follows.

  1. The GSEs should be preserved, mainly because they are the most effective institutions for providing liquidity to the mortgage market.  Most mortgage investors, including depositories, prefer to hold liquid securities rather than illiquid whole loans. Wall Street securitization is not a substitute.
  2. Fannie and Freddie should be chartered as special-purpose banks, playing their historical roles of securitizing mortgages and holding some portfolio of loans.  Their debt should be federally insured or guaranteed, as are the deposits of banks, and as with banks, the equity of the institutions should be the first backup to bondholders as the capital (or equity) of banks is the first backup to deposits. Their insured or guaranteed debt should not be counted as part of federal debt, as the insured deposits of banks are not. They should be subject to capital standards and supervision of their activities, and subject to restrictions on their activities, like banks.  The capital standards, activity restrictions, and supervision need not be identical to those of banks.
  3. It is important to have two GSEs to assure competitive pricing of the guarantees on mortgages which go into MBS pools.  Guarantee fees are not posted prices, but negotiated in secret.  As a result, the pricing of guarantee fees is not collusive but  close to perfect (Bertrand) competition with two GSEs. In the trade-off of standardization and homogeneity to promote liquidity (which calls for fewer GSEs) vs. competition to assure competitive pricing (which calls for more), two gets an excellent result, likely the best result.
  4. There are three choices for F&F ownership:  1) owned by the government, like FHA and Ginnie Mae; 2) owned as a cooperative, by member institutions, as both once were, and 3) owned by the general public. Fannie and Freddie should be owned by public shareholders, as banks are.  We advocate ownership as public companies, but with explicit and priced federal backing, like banks.

Securitization is most efficiently done by institutions that isolate default risk and create homogeneous securities.

The most important reason to preserve the role of the GSEs is that they bring standardization and liquidity to the mortgage market, both in terms of the loans they securitize and in the structure of the mortgage-backed securities (MBSs) created from mortgages.  This standardization makes their MBSs more liquid, and as a result of greater liquidity, more valuable.  More valuable MBSs feed back to lower interest rates for mortgage borrowers.  There are two features of GSE securitization that are valuable.

The very first effort at mortgage securitization was undertaken by Ginnie Mae, a 100% full-faith-and-credit government institution, designed by bureaucrats. This was part of the reorganization of Fannie Mae in 1968, done to get Fannie’s debt off the federal books.  Ginnie Mae securitized already federally-insured mortgages made through FHA.  The additional guarantee of timely payment of interest and principal from Ginnie Mae was a small extension of the federal backing.  But the results were dramatic:  the creation of Ginnie Mae lowered FHA borrowing rates by 60 to 80 basis points.  With the real, long-term mortgage interest rates in the region of 4 to 5%, this was a large, not small, change. This seemingly small transformation of a federally-insured mortgage into a federally-insured liquid security made a big change in the cost of homeownership.

Evidently, all holders of mortgages, even the banks and thrifts who originated loans, preferred holding liquid, securitized mortgages over illiquid whole loans.  Depositories (banks and thrifts with insured deposits) and other federally affiliated institutions (Freddie, Fannie, and the Federal Home Loan Bank) remain the largest investors in the outstanding MBSS created by Ginnie, Freddie, and Fannie today. 

Ginnie Mae could only securitize loans insured by FHA or guaranteed by the Veterans Administration.  So the thrifts quickly created Freddie Mac to securitize mortgages for the part of the market known as “conventional”, the slice larger than FHA will insure but smaller than “jumbo”. Freddie was up and running by 1970.  Fannie began to securitize mortgages in the late 1970s. 

Why is their approach to securitization so successful and why can’t Wall Street financial institutions duplicate it?

First, Freddie and Fannie isolate the default risk on their MBSs by guaranteeing them against default risk.  Investors in F&F MBSs bear only the risk of changes in value coming from interest rate fluctuations, including prepayment risk. Risk from default losses remains with the shareholders of F&F. It is not the elimination of risk so much as the elimination of the need for continuous re-evaluation of risk on individual MBSs that is important. Guaranteeing the pool of loans against default relieves the security holders of the necessity of re-analyzing and re-valuing the default risk of the security. If security holders did have this burden, investors would put a lower value on the securities because of the cost of investigation necessary before undertaking an investment, and because different MBSs hold mortgages from different parts of the country, their default risk would vary from security to security. Isolating this ongoing re-valuation is efficient. Once the loans are made, they cannot be unmade, so time spent analyzing them only contributes to reckoning what today’s price should be, and cannot retroactively improve the allocation of capital.

Continuous analysis of the risk is necessary regarding the equity claims on F&F. Assigning the default losses to the single pool of equity claims in F&F is better than having the default losses fall on individual MBSs, which would vary in value depending on their different default rates. 

When private entities such as individual banks or investment banks securitize mortgages, (all subprime MBSs were private-label securities, not Fannie or Freddie MBSs) they do two things differently.  First, the default risk is borne within the MBS. The risk is generally not taken on by the issuer (as with Fannie and Freddie), or laid off to an insurer (as with FHA mortgages securitized into Ginnie Mae MBSs).  Second, a private-label MBS is then divided into pieces or tranches depending on when and if principal payments are made. Some pieces have greater risk exposure to defaults by borrowers.  Some pieces have more exposure to prepayment risk by borrowers.  And some piece, however small, has a high probability of repayment and can thus be rated AAA. Because the pieces are not standardized, they cannot be as liquid.

The F&F default risk guarantees do for MBSs what insurance does for municipal bonds.  Many municipalities are small, or obscure, and it would be a burden for the market to gather and process the information to keep up-to-date on them.  To relieve the market of this burden, the municipalities who issue the bonds buy insurance against default.  Their bonds are guaranteed against default by the insurer. Thus, the burden of investigating and monitoring lies with the insurance company, not the market.  So long as the insurance company is solid (an issue in the recent crisis) the market can trade bonds of the same maturity but different locales as essentially identical.

A second feature of Fannie and Freddie’s MBSs is that they efficiently suppress information about the location of mortgages in individual MBS pools. Even with the guarantee against default, investors face another risk that varies slightly (much less than default risk) from one region to another:  different speeds of loan prepayment.  Some areas have higher turnover, and loans prepay when people move, and partly because from the point of view of an investor in an MBS with a default guarantee, a default looks like a prepayment:  the investors gets her money back when the loan either prepays or defaults (with a guarantee.)  So how do the GSEs keep the MBS market liquid despite some geographical differences in prepayment speeds?  By not revealing the geography of loans in any given MBS. Wait!  What about market transparency?     

More transparency is not always better.  This can be seen in another institution in the municipal bond market.  A structure used for promoting liquidity in the municipal bond market is a random call feature used for bonds that fund small but long-lived projects. Take a dam, for example. Bondholders are repaid from citizens’ water bills. Such bonds are often structured in sets that repay at different times, for example, 10 years, 11 years, and so on up to 40 years. For little projects, each slice may be too small to find a liquid market. Instead, the entire issue is given the same maturity, but a specified fraction of it is called at random for repayment each year. The investors buy many such issues, and thus have a good idea of when they will be repaid, easily tolerate the uncertainty, and value the greater liquidity.

Suppose that right after the bonds were sold, the issuer spun the wheel to select the call date of each bond. Would it be efficient to release the information early, prior to the call? NO! Once the call dates were known, the bonds would degenerate into the tiny, illiquid serial bonds that the market was trying to avoid. What’s more, the issuer and the investors agree that the best arrangement is not to reveal early. This is a clear case where the optimal level of information is not the fullest.

In principle, the value of an MBS could be either increased or decreased revealing information that distinguishes them from one another. More pieces might accommodate a greater variety of investors with pieces precisely tailored to their risk tolerance.  Or, it could be that liquidity concerns dominate, and that a larger, more homogeneous, more liquid market in MBSs tightens spreads and lowers prices.  There are different ways of addressing risk, including pooling risk (MBSs vs. whole loans, even S&P500 futures vs. individual stocks in the S&P500) (see information theorist Hal Varian’s provocative ideas on subprime koolaid ), providing ratings (professional opinions on risk to make clear where similarities lie), and providing insurance (assignment of risk to a professional evaluator of risk for a fee).  Each has its pros and cons.

The experiment to show which is more important has been done:  Some years ago Freddie Mac was persuaded to reveal more about the geography of its MBS pools on the theory that this would make the pricing more accurate.  Since then, Fannie’s securities (MBSs) have consistently sold for a slightly higher price than Freddie’s because Freddie tells the market more about each one, and hence they are less like one another, and a bit less liquid.  The Fannie MBSs are more alike because the market has no information with which to make distinctions among them.  The really interesting thing is that the market prefers the security about which it is less informed. Over the period since 1998, the current coupon yield for Freddie MBSs has been above that for Fannie MBSs by on average 3 basis points, with a standard deviation of 1.5 basis points.  From January 1998 to December 2008, the yield on the Freddie security was never below that on the Fannie security. And this is despite the feature that the Freddie securities pay the security holder slightly earlier, which in principle should make them more valuable.  Yes, more transparency makes the securities of lower, not higher, value, on average.

So perhaps the Freddie securities are more accurately priced, but they are less valuable as a result. 

By the way, the most complete federal guarantee does not necessarily imply that there is a substantial federal subsidy.  FHA mortgage insurance has, through its history since 1934, covered costs through its insurance premiums (with periodic adjustments).  The single-family part of Ginnie Mae has been a solid money-maker since inception.

 

The 30-year, fixed-rate, prepayable mortgage is unique and is not obviously viable without special federal support.

A large fraction of Fannie, Freddie, and Ginnie MBSs are still held by banks and thrifts with insured deposits, the Federal Home Loan Bank system, or by Fannie and Freddie themselves—in other words, under the federal umbrella. These MBSs contain almost exclusively 30-year, fixed-rate, prepayable mortgages.

The United States is unique in having a 30-year, fixed-rate, prepayble mortgage.  Other industrialized countries have mortgages with long (25-30) lives, but only in the US do they have an interest rate that is fixed for the full term and the loan is prepayable.  Only Denmark, population 6 million, has anything close. Other industrialized countries do have long-term (25 to 30 years) amortizing loans, but the rates adjust at least once every 5 years.  As even we in the US have experienced, long-term, fixed-rate prepayable loans can cause systemic trouble.

The prevailing mortgage rate must anticipate the rate of inflation over the life of the loan. When the rate of inflation rises (as it did in the 1970s), loans become less valuable. Depositories who borrowed short (in the form of deposits) and leant long (in the form of mortgages) became insolvent when inflation rates and interest rates rose.  By allowing federally-related institutions to make and hold mortgages of this design, we assign the systemic risk to taxpayers (who insure deposits explicitly, and stand behind Fannie and Freddie either implicitly or explicitly depending on your reading of current events).  Given that nearly all income taxes are paid by homeowners, and that nearly all homeowners begin their home ownership with a mortgage, the beneficiaries of the system (homeowners, who are comforted by the fixed nominal payments) and the bearers of risk (the taxpayers) are ultimately the same folks. Only a country that was fairly optimistic about its ability to manage monetary policy would undertake such a program.  

If the loans are at some times a problem, why not, like the other industrialized countries, allow only adjustable rate loans?  Why bother to support the 30-year fixed-rate prepayable loan?  Because the payment fixed in dollars comforts borrowers so much.  This is evident first, from the observation that borrowers only choose ARM loans when interest rates are high and the term structure steep; when rates fall, all but the least-cash-constrained ARM borrowers refinance into fixed-rate loans.  It is also evident in focus groups.  Anyone who has observed focus groups discussing mortgage choice cannot but come away with a new appreciation for the security borrowers feel they get from loans with constant nominal dollar payments. Alan Greenspan may be right that this is an irrational, or silly, view, but as we saw when he suggested we do away with the 30-yr fixed-rate loan and make all mortgages adjustable-rate, the general public does not agree.

 

What about the portfolios?     

F&F both have substantial portfolios of loans. Their portfolios are close to three-quarters of a trillion dollars each. We do not have a strong opinion on how large the F&F portfolios should be.  But we do expect that any policy to whittle down the portfolios would only result largely in depositories holding more mortgages and MBSs than they now hold.  In other words, the 30-year fixed-rate loans are not likely to leave the Federal umbrella, but only move to another place under it. Reducing the portfolios of F&F would not be without pain for the mortgage and housing markets.  Even in the early 1990s, when the mortgages held by the insolvent thrifts had to find a new home, mortgages rates were clearly elevated by this displacement. We cannot imagine that policy makers would choose any time soon to force F&F to sell their portfolios, as this would just depress mortgage values and force already beleaguered banks to make down their assets once again.  If the portfolios of F&F are to be whittled down, the least disruptive option may be to simply not have them buy any more loans for portfolio.  As loans in the existing portfolios mature, the portfolios will shrink.

 

What about covered bonds? 

Covered bonds have been promoted by some as superior to asset-backed securities.  We see them as nearly identical, especially to Fannie and Freddie MBSs.  Covered bonds are, like asset-backed securities, backed by the cash flows on a pool of assets, in the case of the mortgage market, a pool of mortgages.  And covered bonds, like F&F MBSs, have more resources behind them than just the mortgages in their pools to cover losses. There are two differences between covered bonds and the MBSs issued by F&F, both essentially cosmetic.  One is that the mortgages backing the bonds remain on the balance sheet of the issuer.  Another is that the pool of assets backing the covered bond is usually larger in principal value than the bonds themselves, so that the security is over-collateralized. The MBSs issued by F&F are essentially also over-collateralized because they are guaranteed against default by F&F, but not by any explicit pool.  If the default losses on a given pool were sufficiently large to invade the principal value of the pool, F&F are obliged to make up the difference from other assets.  Thus, in essence, F&F MBSs are over-collateralized.  So long as the securities outstanding as MBSs, and the experience on the mortgages behind them (in terms of defaults and prepayments) are well-disclosed, and the other assets are also fully disclosed, as those of F&F are, it should make no difference whether the securities are called covered bonds or MBSs or whether the recording of the securities is on the balance sheet or in some other part of their regular reports.

Private-issue MBSs are seldom over-collateralized.  Instead, there is a single pool of loans, and it is securitized, usually with the default risk isolated in a particular part of the pool.  If defaults exhaust the principal in this the high-risk part of the pool, then additional losses invade the other, higher-grade pieces. This happened with the securitized subprime loans.  Anticipating that there was a large fraction of the principal value due on subprime loans that would surely be repaid, some pieces or tranches were rated AAA.  As losses threatened to exceed the value of the pieces bearing the first losses, these additional losses threatened the higher-grade tranches, which caused them to be downgraded and to fall in value.  This decline in value was then marked-to-market on the balance sheets of institutions holding them, (both F&F and larger commercial banks and mortgage banks), and some were, as a result, insolvent.  It appears that the banks that securitized the loans (Bear Stearns, Merrill Lynch, Lehman, Citigroup, Countrywide…) were holding the first-loss, riskiest pieces.

 

Organization and Charter

What about the conflict of private profits and public mission at F&F? 

We do not see any more conflict in having Fannie and Freddie owned by public stock holders and operating with a federal guarantee than we see for banks and thrifts organized in the same way. It is true that part of why F&F are so successful at funneling capital to the housing market is that they had implicit, now explicit, federal backing.  This is true of the entire banking system as well.  Indeed, it appears that the 30-year fixed-rate prepayable mortgage loan is not sustainable in a free market, and that government support is necessary for its existence.  The bulk of such mortgages have been held in institutions that are under the federal umbrella, either depositories, F&F, or the Federal Home Loan Banks, since they were created by FHA in 1934. 

The continuous hostility of the Wall Street Journal and the American Enterprise Institute to Fannie and Freddie is somewhat baffling.  They complain in particular that F&F operated with the presumption of federal backing but earn profits like private institutions.  How is this so different from what insured depositories (banks and thrifts) do?  The WSJ never complains about deposit insurance for banks.

The banks themselves are also not exempt. Ken Lewis, the head of Bank of America (an insured depository), said just a few months ago, in November 2008 at a gathering in Detroit:

…the financial crisis also exposed the inherent conflict in the structure of Fannie Mae and Freddie Mac. The GSEs were asked to serve the interests of private shareholders while fulfilling a public mission, all with “implicit” backing of the government. …. Their move in recent years to purchase lower-credit quality loans helped to fuel that market.   … It was heads, investors win… tails, the taxpayers lose. We don’t think that’s a sustainable model.

Was there no similar conflict at the Bank of America? We imagine he feels a bit foolish about these comments today, having resisted one capital infusion on the grounds that his bank did not need it, but now pleading for, and about to receive, another.  But he should have felt foolish long before, even been inhibited from making such comments, given that he runs an institution that also operates with federal backing, and could leave the taxpayers with vast liabilities. Bank of America should have deposit insurance, but it should fess up to not being an entirely free-market entity.

 

Ownership Structure

Why not a coop?  Time was when F&F were each organized as cooperatives, (though not at the same time, see the short history of F&F at the end of this discussion) owned by the lenders whom they served. In those times, the largest commercial bank in the US had less than one percent of bank assets. While US banking is still competitive today, it is more concentrated now, and a handful of banks now hold close to half of bank assets. The conflict between smaller banks and larger banks in how the GSEs should be run would be greater now than it was in their former co-op days. We believe there are good reasons not to allow the largest banks to run the GSEs to the disadvantage smaller banks. Smaller banks deserve an important place in our banking system.  There is accumulating evidence that smaller depositories treat their customers in a less exploitive way than do newer and less regulated financial institutions. In particular, they are less inclined to exploit financial confusion on the part of borrowers.   See Stango and Zinman, Buck and Pence, and Agarwal et al. on the mortgage counseling experiment in Illinois.

Why not a government program like FHA?  FHA and Ginnie Mae are playing a large and important role right now, with a market share of originations in 2008 of 25 to 30%. For some years, FHA has operated at a disadvantage to the conventional market because of the rigidities inherent to being part of the bureaucracy.  First, FHA originations are slower than originations through F&F.  According to FHA’s January 15, 2009, report on recent originations, average processing time was 2.5 months, roughly 10 weeks, from application to closing, even though most transactions used streamlined systems. FHA was slower to create automated underwriting systems, introducing them only after Freddie and Fannie both had systems in place.  Second, FHA is more vulnerable to exploitive policies on the part of lenders. Fannie and Freddie have more flexibility for thwarting and discouraging exploitation by lenders. F&F can also adjust its guarantee fees to reflect its experience with a given lender, while FHA insurance premiums are one-size-fits-all. There have been episodes of lender exploitation of FHA (seller “gifts” of downpayments to borrowers, implicitly raising the loan-to-value ratios and default rates) that required legislation to fix that would have been promptly corrected by internal policies at Freddie and Fannie.

Why two GSEs?

One might think that with only two organizations securitizing mortgages, we would see tacit collusion outcome such as we get when two gas stations are on opposite corners.  If one station lowers its price, its rival across the street sees that change at least as soon as any customer.  The rival can respond instantly.  The first mover sells no more gas, he just sells the gas for less. Thus, there is no incentive to lower price when the rival sees the change at least as soon as the customers do.

Freddie and Fannie don’t post their guarantee fee.  Each deal is negotiated, customized, and secret.  The ultimate results are seen only in quarterly summaries of business activity.  Thus, customers do know price before rivals do, and know much more about the details of each deal.  Two GSEs thus reach an outcome close to competitive, but give the maximum benefit of standardization and size for liquidity.

In principle, the Federal Home Loan Bank system could have created a third securitizing GSE.  It has not, despite some efforts in that direction.  We imagine that the reason it has not is that there are some conflicts of interest among the members about how the entity should be structured, with larger institutions wanting more power than smaller ones.  They have a collective action problem.  They cannot create a facility only for some members, and have been unable to negotiate to create a facility appealing to all. 

 

What should be different?

The new charters for Freddie and Fannie should 1) establish higher capital requirements for Fannie and Freddie, and 2) have different capital requirements for different lines of business, in particular higher-default risk business. 

We won’t go on too long about this issue because we have already written about it earlier.  We are not optimistic that we can alter asset markets to entirely avoid price bubbles (we seem to have had them from time to time as long as we have had asset markets, and they can be produced in experimental settings too), either in the stock market or the housing market.  But if our financial institutions are less levered, the bursting of a price bubble is of less consequence.  Given the big decline in house prices, it was inevitable that we would have a big decline in residential construction (the high prices resulted in over-building), which means a recession.  Did the credit crisis make things worse? It is not yet clear how much the financial crisis and credit freeze added to this recession, but surely, it cannot have made it less severe. 

Did Freddie and Fannie cause the subprime crisis?

The charters of the GSEs preclude them from securitizing subprime loans.  Thus, they were unable to support subprime lending by any commitment to funding or securitizing them.  They were followers, not leaders. When Fannie and Freddie did buy was some higher-rated pieces of subprime MBSs created by Wall Street.  The ratings on these securities fell when the subprime loans began to default in large numbers. Freddie and Fannie also bought some Alt-A loans (these are loans to borrowers with good credit scores, but which are not as fully documented with respect to borrower income and assets as are prime loans) for their portfolios. They have lost money on these also. Despite their losses, their loss rate is less than one-third the loss rate of the 67 mortgage banks with assets of more than $10 bn.

We would hope that going forward, there would be more regulatory oversight of Fannie and Freddie, and that they would have higher capital standards. Of course these recommendations are not unique.  Nearly everyone is calling for more oversight of any entity with any connection to mortgage lending.

How big a difference do Fannie and Freddie make?

Most of the time, rates on mortgages that were eligible for purchase or securitization by Freddie or Fannie have been cheaper than larger, ineligible loans (“jumbo” loans) by 25 to 40 basis points.  When the credit crisis began, one of the early manifestations of it was a great widening of the jumbo-conforming spread, out to 140 basis points (that’s 1.4 percentage points) and higher.  The gap still stands at about 140 basis points. 

ffpic 

A short history of Fannie Mae and Freddie Mac, and the Federal Role in housing markets.

The 30-year, fixed-rate, prepayble amortizing mortgage was created by the FHA in 1934 as part of a program to revive the market for home loans: to encourage besieged banks to lend and wary consumers to borrow.  Prior to the creation of FHA, loans for buying homes and farms had much shorter terms (three to ten years) and borrowers paid interest regularly, but the principal amount was all due at the maturity of the loan, as the principal on a bond is due upon the maturity of a bond.  Homeowners either saved aggressively (creating their own sinking fund, in effect) as they were paying interest or planned on refinancing to a new loan when the term was up.  We would now call this structure a balloon mortgage.  So both the long term (30 years vs. three to ten) and the amortizing nature (paying both interest and principal each month) of the payment stream represented a new loan design. 

Around this time Congress passed two other pieces of legislation regulating financial institutions, the Glass-Steagall Act and the McFadden Act.  Together, they inhibited the movement of capital among banks and across State boundaries.  The McFadden Act prohibited banks from having branches in more than one State.  The Glass-Steagall Act prohibited banks from creating and selling securities.  With nationwide branches, a bank could move capital from Idaho to North Carolina when more capital was demanded in North Carolina.  If banks could have created and sold securities, they could have obtained new capital to lend by selling loans they had already made.  Congress saw the difficulty created by Glass-Steagall and McFadden, and in 1938, established the Federal National Mortgage Association, FNMA, which came to be known as Fannie Mae, to compensate for the barriers to capital movement erected by Glass-Steagall and McFadden.

Fannie was originally organized as a cooperative.  Banks that did business with Fannie (by selling loans to Fannie) also were investors in Fannie and provided Fannie’s capital in proportion to the amount of business done. Fannie grew slowly from 1938 until after WWII. 

In the 1960s, there were many pressures on the federal budget, including the war in Viet Nam and the programs of the Great Society, and Fannie Mae’s debt, which was at that time counted as part of the federal debt, loomed.  A federal budget task force was organized in 1968. One of its assignments was to get Fannie’s debt off the federal balance sheet.

This was done by two substantial re-arrangements.  The first was to re-organize Fannie as a public corporation, with stock owned by the general public, not just by banks, and traded on the stock exchange. The corporation would issue bonds in its own name and use the proceeds to buy mortgages for its portfolio. Fannie would no longer be a bank co-operative.

The second was to take the FHA-insured loans (which represented an explicit Federal liability because of the full-faith-and-credit insurance) out of the Fannie Mae portfolio and pool them into mortgage-backed securities, then to sell these securities. A given security gave its holder the right to the payments of a specific set or pool of loans. The FHA insurance relieved the security holder of any risk coming from defaults by FHA borrowers.  If borrowers prepaid, however, prepayments would flow straight through to security holders.  Thus, if interest rates fell and homeowners refinanced at lower rates, Ginnie Mae security holders would get their principal back at a time when their reinvestment opportunity would be at a lower rate. On the other side, if interest rates rose, the likelihood of prepayment would fall, making it more likely that the loan would remain outstanding for its full 30-year term. This interest-rate risk, in which the investor loses due to prepayments if interest rates fall, and loses by virtue of a lower-valued loan if interest rates rise, is an important and defining feature of the 30-year, fixed-rate, prepayble mortgage loan. The risk for MBS holders was not different for the risk banks had always taken in making such mortgages, but it was a new feature for a liquid, traded security.

The securities created from FHA mortgages were then given a further guarantee of timely payment of interest and principal, through the newly created Government National Mortgage Association, known as Ginnie Mae. Ginnie Mae’s guarantee is a full faith and credit US federal guarantee.  The additional burden to the federal government from this additional guarantee is de minimis, because the loans are already insured by FHA against loss of principal from default. Ginnie only has to pony up when a loan defaults, giving the security holder her principal back immediately, then waiting to collect the principal from FHA once foreclosure is complete. Ginnie gets 6 basis points of interest from the loan pool for this promise and has lost no money on the deal.

The success of Ginnie Mae was immediate and astounding.  Within a year, it became clear that the creation of Ginnie Mae and its ability to turn illiquid, hard-to-evaluate, hard-to-sell, whole loans into liquid, easy-to-sell securities lowered interest rates on FHA loans by 60 to 80 basis points!  Given that the real (inflation-adjusted) rate of interest on FHA mortgages had averaged around 4 to 4.5 percent, this was a big change, not a small one. 

Ginnie Mae’s success made the thrifts (also known as Savings and Loan Associations, which have insured depositories, like banks) want a similar facility for loans larger than what FHA would insure.  Within two years, by 1970, the Federal Home Loan Bank Board, which then governed the thrifts, had such an entity up and running in the Federal National Mortgage Corporation, now known as Freddie Mac.  

Freddie was also operated as a cooperative.  The thrifts (and banks) who did business with Freddie put up the money to provide its capital, and were in essence its owners (through their ownership in the district-level Federal Home Loan Banks, and these district banks held Freddie’s stock directly). Freddie’s activities were very different from those of Fannie. Fannie issued bonds and bought mortgages and held them.  Freddie issued a few bonds, and used the money to buy mortgages, but then packaged the mortgages, attached its own guarantee against default risk, collected a little fee for this guarantee, (like FHA’s, but not explicitly federal), and sold the packaged loans as securities, much the same as Ginnie Mae did. Freddie’s primary activity was to securitize mortgages, not to hold them in portfolio. Freddie’s portfolio was essentially just a small liquidity facility until Freddie was privatized in 1989 as part of FIRREA. 

Okay, now for a diversion into the thrift crisis.  Be patient.  In a page and a half we got from 1934 to 1980. 

The rate of inflation had been rising through the 1960s, and by the 1970s it was up in double digits. The lenders who had made 30-year mortgage loans at 5 percent, 6 percent, and 7 percent were facing much higher rates than this to be paid for funds, and as a result, were insolvent.  The value of their assets, the loans on their books, was lower than the value of their liabilities.  The essence of their problem is that they borrowed short-term and invested long-term (in mortgages).  If interest rates rose, what they had to pay for money also rose, but the rates they got on their old loans did not. The interest they received on their assets did not cover the interest they paid on their liabilities.  The interest rate on one-month Treasury Bills reached a maximum of 21 percent in early (February) 1980.

The thrifts and Fannie Mae were essentially in the same tough place, seriously under water, on a market-value basis in 1980. The thrifts had assets with a market value of $700 billion, and liabilities of $800 billion.  Fannie had assets with a market value of $70 billion, and liabilities worth $80 billion. But the deal between them and their guarantors (the federal government itself and insured federal depositories) was written in terms of book values, not market values, and there were no requirements to use mark-to-market accounting, so the institutions—banks and thrifts and Fannie—continued doing business while praying (along with a host of policy makers) for lower interest rates.  The contrast between this insolvency, which was profound but not manifested in lender operations due to the prevailing accounting rules, and the current one, in which recognition of the insolvency has resulted in a full-blown credit crisis, is stark. We still speak of the “thrift crisis”, but the current financial crisis is much more crisis-full than was the thrift crisis. This does not necessarily mean the old way was better, but more on that later.

Note that as of 1980, when interest rates were at their peak, Freddie was entirely solvent.  By virtue of only securitizing mortgages, and not holding and financing them in great volumes, Freddie faced no great interest rate risk. 

So what happened in this great insolvency?  Well, first we had a recession.  Not because the thrifts were broke and wouldn’t make loans, but because the efforts that were made to bring the rate of inflation down first resulted in a sharp rise in short-term interest rates. The rise in interest rates starting in 1979 brought a decline in residential construction of more than 40% from 1979 to  1982, and then, as now, construction is a sufficiently large sector (about 5% of GDP) that when construction contracts by this amount, this contraction resounds around the entire economy.  It was a very costly recession.

But the policies put in place to bring lower inflation succeeded, and in fits and starts, rates fell through the 1980s.  Along the way some thrifts became insolvent on a book-value basis and had to be dissolved. More thrifts were insolvent on a market-value basis, and took extra risk because if they took risk and won, fine. If they took risk and lost, that was fine too, because they were in the hole anyway and the new risk was taken with Other People’s Money (mainly the taxpayers’).  The obvious strategy for an insolvent thrift was to take some risk and try to get out of the hole. In 1989 Congress acknowledged this problem and provided the funds to close the remaining insolvent thrifts through the Financial Institutions Reform, Recovery and Enforcement Act, FIRREA (pronounced Fie-REE-Ah).  In the meanwhile, Fannie Mae had become solvent again from lower interest rates.  

Once Freddie was privatized (also part of FIRREA), it immediately issued bonds on a great scale and accumulated a portfolio of mortgage loans. And as Freddie’s securitization program had been obviously successful, Fannie had begun securitizing loans also by the early 1980s.  Thus, by the early 1990s, their structures and activities were essentially identical. 

Okay, that’s the end of the history lesson. 


Consumption Surprise

January 2, 2009

Commentators have been exclaiming over the decline in consumer spending in recent months. It’s true that spending in dollars is down, but an interesting fact has escaped attention: In November, the volume of consumption rose, despite a decline in spending. The reason is that prices fell. We used to talk about adjusting consumption and other components of GDP for inflation, but now we have to consider adjustments for price declines. The two pictures show durables and non-durables consumption, adjusted for price declines.

condur

 Consumption of durable goods, adjusted for price declines

 

connondur

Consumption of non-durables and services, adjusted for price declines

It’s way too early to say what this means. The December data will be helpful. We may get some grip on the question of how much of the drop in consumption was the reaction to the spike in oil prices during the summer and how much from the financial events of the fall.


What is the Fed up to?

January 2, 2009

The picture shows the major components of the Fed’s balance sheet in recent years. Some things have remained the same—contrary to the many claims that the Fed has been printing money like crazy in the past few months, the amount of currency in circulation has risen only slightly more than normal. The really big change is the expansion in the Fed’s ownership of assets other than in the traditional form of Treasury securities. The Fed has increased its holdings of non-Treasury assets by about $1.7 trillion. Some of the assets are loans to banks and other financial organizations secured by financial assets and others are direct holdings of financial claims. The Fed has bought up financial assets because investors appeared to be shunning them. The Fed feared the consequences of attempts to sell these assets in markets without buyers who valued them.

The Fed financed these investments by selling about $300 billion of Treasury securities it owned and by borrowing huge amounts from the Treasury (currently about $400 billion in deposits from the Treasury at the Fed) and from banks, in the form of vastly expanded reserves (almost $800 billion at yearend). Reserves are just another form of borrowing at this point and have no special role in the monetary system. The reason that many commentators have mistakenly thought that the Fed was printing money was that reserves used to function like money, under previous monetary institutions.

fed

Federal Reserve Assets and Liabilities.


Measuring the Effect of Infrastructure Spending on GDP

December 11, 2008

 

The Obama administration’s focus on infrastructure spending raises the natural question of the effect of government purchases on total GDP. Does government spending stimulate other categories of spending, especially consumer spending? Or does government spending displace other categories, so GDP rises by less than the amount the government spends?

Valerie Ramey has written a paper with the results of her recent work on the question and with a full bibliography of earlier work. Her answer is that consumption and other categories stay about the same when the government spends more. In other words, the increase in GDP is about equal to the increase in govenment spending. To focus on changes in government spending that are not themselves responding to conditions in the economy, she considers military spending. She finds that GDP rises by about the same amount as an increase in military spending.

The picture below shows GDP and government military spending during World War II, both adjusted for price changes, detrended, and rescaled to the level of the U.S. economy today.  If you think that the Obama administration is ambitious in spending a trillion dollars over several years on infrastructure projects, note that military spending maxed out at $7 trillion per year during the war, rescaled to the current size of the economy. During the expansion, GDP rose pretty much the same amount as did military spending. Consumption and other components of spending neither rose under the military stimulus nor fell because of displacement by military spending. The two forces offset one another. Notice, however, that when military spending fell after the victory, GDP did not fall nearly as much. Consumption and other components expanded rapidly to take up the resources freed from military activities and there was little sign of adverse effects from the lower military spending.

ww2

The second picture shows the same variables for the buildup at the beginning of the Korean war. The story is much the same-equal increases in military spending and GDP.

kor

Although military spending expanded in three other episodes-Viet Nam, the Reagan buildup, and post 9/11-none of these expansions was large enough to give much additional evidence on the response of GDP to increases in military spending.

We believe that the one-for-one rule derived from wartime increases in military spending would also apply to increases in infrastructure spending in a stimulus package. We should not count on any inducement of higher consumption from the infrastructure stimulus but we should also not worry that infrastructure spending might displace consumption and other categories of spending.


Options for Stimulating the Economy

December 8, 2008

 

In 2009, GDP in the U.S. is expected to be about $900 billion below its normal growth path. The ideal stimulus would have most of its effect in 2009 and would close a reasonable fraction of that gap. We see five general strategies for stimulus:

  • Further expansion by the Fed
  • Income tax cuts with rebates, as earlier this year
  • Tax cuts that reduce the prices of consumer goods temporarily
  • Tax cuts that reduce the cost of labor to businesses
  • Increase in purchases of goods and services by state and local governments

 Expansion by the Fed

The Fed controls short-term interest rates by adjusting the quantity of reserves it supplies to the banking system. To lower rates, the Fed buys securities and pays for them with reserves, thus increasing the total quantity of reserves at banks. Banks then try to alter their portfolios to move out of reserves and into higher-paying assets, including loans. The increased demand for these assets reduces their interest rates and stimulates investment and consumer spending. The Fed and other central banks have been using procedures based on the principle that the central bank can adjust overall conditions in an economy to keep it on an even keel, with low stable inflation and relatively mild booms and busts. The principle has worked well in most countries over the past 25 years. The main exception was Japan in the 1990s, where the principle broke down in the same way as in the U.S. today.

The logic above indicates that thre is no scope for further expansion in this way. The reason is that the Fed pays 1 percent interest on reserves, which is above the rates that banks can obtain from other similarly safe short-term investments. An expansion of reserves leaves banks with more of an asset they crave because banks prefer reserves at 1 percent to loans at a higher rate; it does not set in motion any process that would result in expanded lending and lower rates for business and consumer borrowers. For reasons we are unable to explain, the Fed raised the rate it pays on reserves recently. The standard analysis of the payment of interest on reserves by central banks makes it clear that increases in the attractiveness of reserves are contractionary. Because the Fed has also increased the quantity of reserves enormously over the same period, we are not saying that the net effect was contractionary, only that the increase in the reserve interest rate went in the wrong direction. (We should add, but only in parentheses, that we support paying interest on reserves at a rate somewhat below other safe rates as a general principle of central banking in normal times.)

Although we believe that restoring the Fed’s interest rate paid on reserves to its traditional level of zero would be a good idea as a temporary stimulus, we do not believe that it would have much expansionary effect in an economy where safe short-term rates are already very close to zero

Fed Chairman Ben Bernanke gave a speech on December 1 explaining the Fed’s plans for further expansion. Oddly, he explained the new policy of paying 1 percent interest on reserves as a way of elevating short-term rates up to the Fed’s target level of 1 percent. This amounts to a confession of the contractionary effect of the reserve interest policy. More importantly, he stated that the Fed might start buying longer-term Treasury securities. He did not describe how the Fed would pay for them. If the Fed expands reserves further, it would be taking the long-term Treasuries out of the market and replacing them with short-term federal debt, namely reserves. If the Fed and the Treasury cooperated, as they have for many other asset purchase and lending by the Fed, the Treasury would issue new debt, place the proceeds in its Fed account, and the Fed would use the funds to buy the long-term Treasuries. In any case, the effect would be the same as if the Treasury by itself retired long-term debt and replaced it with short-term debt. There is much to be said for this policy. Based on current interest rates, it would give investors what they want, more short-term Treasury debt, for which they require interest rates close to zero, and less long-term, for which interest rates are rather higher. The policy would probably save the taxpayers a lot of money. But nobody thinks that it would have much effect on interest rates. Notice that any downward effect on long-term rates would be offset by an upward effect on short-term rates. The federal government needs better coordination on this issue. At the same time that Bernanke said the Fed would buy long-term Treasury bonds and finance the purchase with short-term federal debt, the Treasury announced that it would sell  10-year bonds in the coming week. How much easier for the Treasury not to issue those bonds and to issue correspondingly more short-term debt!

Although Chairman Bernanke did not use the term, the policy of substituting short- for long-term debt through the central bank is called “quantitative easing.” There are good reasons to go ahead with the policy, but it seems quite unlikely to give much net stimulus to the economy.

Income tax cuts with rebates

Last summer, consumers enjoyed a moderate tax cut paid out to most people as an immediate rebate. The experience demonstrated that the federal government is capable of a speedy fiscal action, but it also showed that consumers don’t go out and spend rebate money when they receive it. Instead, just as the received theory of consumption predicts, consumers smooth the spending increase, reserving most of it for future consumption, by saving it or using it to pay down debt. It raises their standard of living more than their immediate spending. It’s good news that most Americans do not have their backs to the wall financially, but it makes an income- tax rebate ineffective as a stimulus concentrated at the time most needed. Rather, rebates result in consumption incrases spread well into the future. The following graph, created by John Taylor in a recent op-ed, shows what happened last summer:

taylor-graph 

Tax cuts that reduce the prices of consumer goods temporarily

The most desirable time-concentrated stimulus would raise consumer spending during 2009 without changing it much in future years. The government lacks the power to compel consumers to spend more, so it must rely on a incentives. Britain has just cut its sales tax (VAT) by 2.5 percentage points for the next 13 months to provide a small incentive concentrated in the period when the recession is expected to be most severe.

An important article in the American Economic Review in September 1986 by James Poterba, Julio Rotemberg, and Lawrence Summers demonstrated the high potency of a sales-tax cut as a stimulus. They studied the reverse situation, where a big increase in the British sales tax caused a severe recession.

Because the U.S. lacks a national sales tax or VAT, the logistics of a temporary consumption subsidy would be a little more complicated. The Kotlikoff-Leamer proposal would operate through state sales taxes. All but a few small states have sales taxes–the exceptions are Alaska, Delaware, Montana, New Hampshire and Oregon. Under the plan, the federal government would buy out sales taxes for the period of the needed stimulus, say the year 2009. The states without sales taxes or with low sales taxes would receive comparable federal funds to cut other types of taxes. Sales tax revenue is currently $440 billion per year, so the proposal would cost around half of what the Obama administration appears to be planning to spend on stimulus.

The plan needs to take effect soon after it is announced. The announcement will cause consumers to defer purchases until the tax cut takes effect. Similalry, toward the end, they will accelerate purchases and then buy less after the sales tax resumes. Phasing in the resumption might be a good idea.

Critics of consumer subsidies point out that some consumer goods are imported, so the stimulus benefits the producing country, not the U.S. Often that country is said to be China, though Japan is also a major source because of its dominance of the world car market. Given that the U.S. has pledged to engage in joint stimulus with its major trading partners, including China, the stimulus to the import source countries is entirely appropriate. But imports of consumer goods are only 18 percent of consumer spending on goods (excluding services), so the leakage into import stimulus is not a major consideration anyway.

We feel that a temporary elimination or reduction in sales taxes would be an effective stimulus to consumer spending, concentrated in the period when it is needed most and phased out later. It should be part of the stimulus plan.

Tax cuts to reduce the cost of labor

If the objective of a stimulus is to lift employment, why not operate directly on that margin, by lowering the cost of labor to employers? The federal government has a completely straightforward way to do this, because it levies a 7.65 percent rate on payrolls for virtually all employment. The tax yields just under $500 billion per year. Elimination of the tax for the year 2009 would provide a substantial incentive to employment concentrated during the year. As with the temporary removal of sales taxes, both anticipation effects and ending effects would occur.

One problem with the employment stimulus is that the funds go in the first instance to the owners of businesses and not to consumers generally. Ownership is highly concentrated in the U.S., so the distribution of the immediate benefits is skewed. By contrast, the consumer rebate can be directed to lower-income consumers because it is part of the income tax and the sales tax reduction at least is in proportion to purchases rather than business ownership.

If the response of employment to the payroll tax cut were strong enough, its contribution to the incomes of workers might be enough to overcome the disadvantage of its business-subsidy character. If business hiring responded aggressively to the subsidy, profits would decline as business put more output on the market and the winners would be workers rather than owners. Everything turns on the strength of the employment effect. But, alas, the strength of the effect depends on one of the most unsettled issues in macroeconomics, the role of supply increases in raising the quantity of output produced in the short run. One line of thought treats this issue just as one would in a standard market, where an increase in supply raises the quantity sold by the principles of the standard supply-and-demand diagram of elementary economics. Another line believes that special principles operate in the short run that makes demand the controlling factor–an increase in supply has little effect on the quantity sold in the short run in this view. We are among the few economists who regard this issue as still open. Most are doctrinaire believers in one or the other view. We are sufficiently concerned about the potential validity of the demand-limiting view that we are reluctant to state with confidence that a supply-based stimulus such as the payroll-tax suspension would have a large effect on employment.

Increase in construction spending by state and local governments

President-elect Obama supports federal funds for state and local construction projects as an element of a stimulus package. Increases in spending are plainly attractive because the response of state and local governments to the federal willingness to support projects is likely to be enthusiastic. Government units have backlogs of projects waiting for funding. The questions are how big are the backlogs, how quickly spending can accelerate, and how beneficial are the projects.

State and local construction spending is currently $300 billion per year. The Obama team is hard at work trying to find out how much of a backlog is “shovel-ready” in the President-elect’s neat phrase. We are not aware of any easy source for this information.

Timing may be a problem, as it was in the old days when these kinds of projects were called public works. Complicated projects take time to ramp up to high spending and employment levels. Some interstate repairs can be executed in a year, as was the case in rebuilding the collapsed I-35 bridge in Minneapolis last year and in re-opening earthquake-damaged freeways in Los Angeles in 1994, while it took many years to reopen all the damaged roads in San Francisco after the 1989 earthquake.

The president-elect has also mentioned less conventional spending programs, including broadband facilities and online medical records facilities.

All of these proposals for stimulating state and local spending suffer from a common problem–they will end up generating employment for highly specialized businesses and workers, rather than stimulating economic activity more broadly. The consensus of macroeconomists across the spectrum is that a spending stimulus raises total spending by between 1.0 and 1.5 times the amount of the direct increase in spending.  The follow-on or multiplier effects are between zero and half the driect increase in spending. Thus a program that funnels money to construction firms and their workers mainly raises their incomes and employment levels and has relatively little effect elsewhere. Rebuilding aging interstates and upgrading the energy efficiency of public buildings calls for highly specialized skills. A large-scale infrastructure program will drive up the profits of the limited number of firms capable of doing this type of work and drive up the wages of the skilled workers who know how to do the work.

It’s hard to imagine that a significant fraction of the large stimulus under consideration for 2009 will take the form of state and local construction and other infrastructure spending. We are hoping that discussion of stimulus will not become sidetracked over this part of the program and neglect the opportunities to stimulate consumer spending broadly without complicated, detailed, and time-consuming decisions.

Conclusions

We foresee a mixture of stimulus policies for the coming year. Monetary policy can only a small further contribution. Income-tax rebates seem to have little support and would probably have relatively small effects within the year, with undesirable continuing effects in later years. We are enthusiastic about removing sales taxes for the year and perhaps somewhat longer, with a phaseout. We are not sure that an employment stimulus from a reduced business payroll tax would raise employment enough to be a contender as a stimulus and to prevent the flowing through of the funds to business owners rather than workers. We believe that some federal subsidies to state and local spending would make sense, but are concerned that too large a program would result in stimulus continuing past the time when it would be needed and that it would create excessive rents for contractors and skilled workers. Thus the sales-tax buyout seems to be the best way to spend the bulk of the stimulus dollars.