“It is to me a new and consolatory proof that wherever the people are well-informed they can be trusted with their own government; that whenever things get so far wrong as to attract their notice, they may be relied on to set them to rights.”

—Thomas Jefferson to Richard Price, January 8, 1789.

Groups like ACORN were invited by House Banking Committee Henry Gonzalez to -

draft statutory language setting the law’s affordable-housing mandates. Interim goals were set at 30% of the single-family mortgages purchased by Fannie and Freddie, and the Department of Housing and Urban Development has increased that percentage over time.

This eventually led to zero percent down mortgages, the (continued) bailout of Freddie Mae and Fannie Mac, and our current credit difficulties. Make no mistakes about it. The economic problems that we suffered over the last 18 months, and continue with today, have their roots in Congressionally-mandated actions to rewrite the standards for credit-worthiness to help facilitate home ownership.

While these were (are) admirable goals, the road to economic hell is paved with good intentions.

It may be an extreme act of hubris to critically comment on the rhetoric of a Nobel Prize winner in Economics. However, he seems to ignores the fact that public stimulus can come in two forms, one through direct government spending (e.g. spending on infrastructure) and transfer payments (e.g. unemployment benefits), and the other through the monetary policy of the federal reserve.

There are several problems with direct governmental spending to support Keynesian goals. First, is that it takes a long-time to get bills through Congress, so by the time the money actually starts flowing, the economy has typically worked through its issues. Second, Congressional priorities are typically not the same as those priorities required to get the economy back on its feet. Thus, the money is inefficiently spent with respect to helping the economy. Third, a true Keynesian spending program would be reduced when the economy is doing well. However, Congress has yet to reduce real spending during any period since 1960 (see chart.)

A much better approach to stimulate the economy is through the monetary operations of he Federal Reserve. As this previous post suggests, the Federal Reserve has made a huge bet on monetary stimulus, to the tune of $13 trillion, far in excess of that requested by Mr. Krugman. This stimulus continues today, and is not just through low interest rates (which may be leading to asset inflation in other countries through the dollar carry-trade), but also through direct purchases of mortgages from Freddie Mae and Fannie Mac (and here). This stimulus is huge. In addition to the direct Federal Reserve purchases for these bonds, the government guaranteed 98% of the residential mortgages in the third quarter, providing an “off-the-balance sheet” stimulus that is not included in any of the accounting for governmental or federal reserve actions.

Mr. Krugman obviously knows the importance of the continued easy money policy of the Federal Reserve. However, it is not clear to me why Mr. Krugman continues to write on the importance of another direct stimulus effort from the government, which would only be a small fraction of what the Federal Reserve and off-the-balance-sheet efforts have already committed to the economy. An expansion of direct spending seems to be more of a political desire for increased top-down control of the economy, than any true desire for more economic stimulus.

I don’t think it is saying capitulation. The volume is not there. There is something different about this market. This is not a dramatic catharsis that like the proverbial phoenix gives rise to a beautiful new bird that flies again. This is the grind, the mashing of metal against metal that suggests something is seriously wrong with the machine.

Since Election Day the DJIA has dropped from 9,625 (11/4/2009) to 6,594 (3/5/2009), down 31%. This in a market that was already down 32% from an all time high of 14,093 in October 2007. Its not supposed to happen like this. And I don’t think the administration is listening. Or if they are, maybe they are hearing something different.

Federal Reserve Balance Sheet - Wall Street Journal

Between the 1929 and 1932, the DIJA fell nearly 90%; and by 1933 GDP had fallen by 45%. There were a lot of bad policy mistakes that were made during that time that contributed to the continued decline in economic activity. The current Federal Reserve appears willing to add trillion of dollars of debt on its balance sheets to avoid the monetary mistakes of the past. However, Congress and the White House seem to have taken a different message from the previous crash and the current one, and seem bent on trying to antagonize capital holders and businesses in ways that have not been seen since Roosevelt.

However, when you consider the market is down 51% from its high, half of which is during the time since a new administration was elected, it would appear that there is a new vote happening. This vote is in the markets and business investment and it is going in a direction that is opposite the one expected by our political leaders. Can they hear it?

So the housing market is to get some direct help. First, by recapping Freddie Mae and Fannie Mac with $200 billion. They are effectively creating at least $4 trillion in new mortgage money if the 20X leverage ratio for these monstrosities holds. More if the leverage ratio is allowed to increase (at the end of 2008 these ratios were 20X and 70X for Fannie and Freddie, respectively). This will continue the path of nationalization of the mortgage industry. Will someone please show me one example where the nationalization of an industry provided the long-term benefits it was meant to secure?

In addition, the administration will now back “cram-down” legislation. This will force the rewriting of mortgage contracts in a bankruptcy filing. The effect of this legislation will be to increase the mortgage spreads to treasuries, as issuers will demand more risk premium for issuing the mortgage. This will insure we will all pay more for our mortgages in the future.

A possible solution to the increasing mortgage spreads will be to “fix” mortgage rates. The administration will be able to do this because they will have effectively nationalized the mortgage market (see above).

Price fixing always fails in the effective distribution of goods and services. It creates winners and losers by subjective rules that have no relationship to individual incentive.

In this perverse case here, Congress forced Freddie and Fannie to underwrite sub-prime mortgages in an effort “increase” home ownership. This led to price dislocation (i.e. a bubble) from too many people chasing too few houses. The pricing bubble led to a misallocation of resources in the housing industry, which built too many houses because of the excess demand caused by the excess available credit.

A tremendous amount of those bubble home purchases are now underwater. And since the owners never could afford the homes in the first place, they find bankruptcy their only option to relieve them of their contractual obligations. The same people in government who set these homeowners up for failure now want to penalize the rest of the housing market with more expensive mortgages.

Look for this severe warning sign, price fixing of mortgages. Either explicitly via mortgage rates, or implicitly via a “credit worthiness” criteria outside of the true bill paying capability of the borrower that helps some buyers over others get mortgages from our national mortgage providers. If you see this happen, our troubles are just beginning.

They point to some of the problems with this proposal, but there are other problems with the government trying to qualify borrowers.  The manipulation of lending standards at Freddie Mae and Fannie Mac for the purpose of trying to expand the ranks of home ownership are what got us into the mess in the first place.  However, imagine if the government errs on the other conservative side of the credit markets (which is exactly what the federal regulators are doing to commercial banking right now).  While interest rates may be 4%, very few people will be able to qualify, and the credit markets will remain frozen.

The Great Depression did not result from the Crash of ’29, but rather the regulatory and monetary practices that followed in response.  Price fixing and regulatory limitation of market are what produced 25% unemployment.

The recent economy was highly leveraged, which resulted in asset inflation.  The over-leverage resulted from lots of reasons, not the least of which was poor regulation rather than the absence of regulation.  The process of de-leveraging the economy will cause asset deflation and economic dislocation, but it does not necessarily have to cause extensive price deflation for other goods and services.  Bad regulation, bad fiscal policy, and bad monetary policy will give us the exact problem they are trying to solve.