Our current economic crisis is not the result of unforeseeable, unfathomable, unfortunate events, but of bad public-policy choices, mostly originating in the Federal Reserve. Fed policy weakened the link between interest rates and the money supply, promoted variable-rate mortgages, decreased the savings rate, ignored the housing bubble when it came to calculating inflation, and decreased the profitability of traditional banking products. After doing all this, the Fed still managed to be surprised by the crisis it created. And it still has not found its way to the most direct solution: reversing the stampede into variable-rate mortgages.
By keeping interest rates too low for too long, the Fed managed to inflate housing prices to unsustainable levels and helped drive capital out of traditional banking products. The Fed’s promotion of variable-rate mortgages now limits the Fed’s ability to raise interest rates without creating an unacceptable economic contraction — when the Fed raises rates, monthly house payments on variable-rate mortgages go up, too, with predictable consequences.
The addiction to ever-cheaper money led to 15 years of refinancing of debt, and now, with the Fed rate at nearly zero, a critical breaking point has been reached. In order to raise capital and stimulate the economy at the same time, variable-rate home mortgages should be refinanced with long-term fixed-rate mortgages, using government subsidies when necessary, to stabilize the housing market. Achieving this would reestablish the Fed’s ability to increase interest rates without causing a housing-market crisis every time it does so.
A little background: In 1993, the Fed effectively divorced interest rates from the money supply and instead began using “real interest rates” — meaning the face-value interest rate on a bond or other investment, minus the rate of inflation — to assess the effects of Fed policy. This is not the best way to make those assessments, and the Fed compounded its mistake by using a flawed method of accounting for inflation, one that excluded asset appreciation — i.e., pretending that the rise in housing prices wasn’t happening. From 1993 to 2007, inflation was quoted in the 2–3 percent range except for 2002, when it hit 1.59 percent. Meanwhile, housing prices were rising 10–12 percent per year.
How could the Fed ignore the run-up in house prices? While 23 percent of the Consumer Price Index (CPI) is an “owner’s equivalent rent,” that measure understates the real price of owner-occupied housing. While the “owner’s equivalent rent” component of the CPI climbed 2–4.6 percent per year, housing prices soared at five times that rate or more. The Fed concluded that low interest rates were justified by low rates of inflation, but its measure of inflation was flawed. Ignoring housing prices, the Fed wasn’t looking for inflation where the inflation was actually happening.
While this approach provided cheaper capital for borrowers, it caused a dramatic decrease in real returns on traditional banking and money-market products, pushing capital into higher-risk products, such as mortgage-backed securities. The allure of mortgage-backed securities was that they were implicitly guaranteed (insured, derived from Fannie Mae or Freddie Mac, etc.) and that they offered rates that beat traditional banking products, which were, in real terms, losing money. While the Fed’s calculations excluded housing inflation, the real world felt it. And so the need for a higher return on capital grew even among conservative investors, because traditional banking products were paying negative real interest rates.
If we want to increase savings over the long run and avoid inflation, the Fed will have to raise interest rates. The problem now is that the Fed’s power to increase interest rates has been compromised substantially by the increased prevalence of variable-rate mortgages. When Alan Greenspan testified in 2004 that Americans taking fixed-rate mortgages were not receiving the full benefit of Federal Reserve policy, he implicitly endorsed a trend that already was under way. The downside of variable-rate mortgages is that they increase the immediate effect of interest-rate changes on the economy as a whole. This amplified the Fed’s ability to stimulate the economy as interest rates were cut. Unfortunately, it also increases the dampening effect on economic activity when rates are raised. When mortgages were fixed, by contrast, the Fed could move interest rates and affect only the marginal cost of borrowing. Only new mortgages were affected.
We need to regain that flexibility. We would like to increase the amount of capital available in the short term while increasing interest rates to induce greater savings over the long run. The easiest way to accomplish this is to lock down variable-rate mortgage debt in long-term fixed-rate mortgages. This creates a necessary floor for the residential real-estate market while making mortgage-backed securities more liquid by decreasing defaults in the short term and creating a stable stream of payments for the long term. It also boosts confidence in what is most families’ biggest asset — the home.
Using government money to lock homeowners into long-term fixed-rate mortgages also allows the homeowner to maintain an asset worth many times more than the government expenditure, a far better investment than the dollar equivalent in either a tax cut or direct payment. This is key: Unlike a one-time tax cut or stimulus check, helping homeowners secure a long-term asset allows the government to multiply the effect of the dollars it spends.
The political appeal of this approach makes it all the more sensible. It will support those who now face foreclosure. It can also be extended to those not necessarily facing foreclosure, increasing its stimulative effect, if necessary.
There are costs. Obviously, there is the direct cost to the government of subsidizing the lower rate of interest. The advantage here is that the wealth effect experienced by homeowners will exceed the expenditure necessary to produce it. There is a large bang for that buck. There is also the cost to those holding mortgage-backed securities, who had expected higher rates of return. But the severity of current conditions threatens even the principal of such investments, not just the rate of return. Any program that stabilizes housing prices makes housing-backed securities more liquid by creating a dependable revenue stream, defining a baseline value that investors can understand. While this plan won’t restore the value of these securities to their pre-crisis levels, it will provide a significant improvement over what investors in these instruments could reasonably expect to achieve under current conditions.
Other approaches — infrastructure spending, industry bailouts, tax rebates or government checks to everyone — create only as much capital as is spent, a simple wealth transfer. So-called investments in green energy or mass transit will fail to provide the capital and stability needed in the short run. And while political types frantically compose symphonies of new regulations or “tax cuts” for non-taxpayers, the fundamental cause of the meltdown goes practically ignored.
We can’t afford to make the wrong call here. We must find our way back to a bank-based capital market that pays people to save and treats houses like the long-term investments they are. But we do not have infinite funds to achieve these goals. The federal debt now stands at $10 trillion. With the expected contraction in Gross Domestic Product (GDP) and a federal deficit over $1 trillion this year, the federal debt could well exceed one year’s GDP within two years. This will sharply curtail our ability to borrow in the future — in terms of both the cost and the availability of capital. How we spend money matters — it always has. It is what brought us to this point and, if we are not careful, it will be what keeps us here much longer than necessary.
– John Mastrobattista is an economic-policy adviser with Gramercy Park Consulting and was the recipient of the Charles Bluhdorn Prize in Economics at Tufts University.