Unbalanced and Unhinged

But the attention of investors, which had hung on to every shred of news or innuendo about the GSE’s last week (like the late breaking and unsourced Reuters report on Friday afternoon that prematurely suggested Fed Chairman Ben Bernanke had opened the discount window to Fannie and Freddie), soon turned to the regional banks. Unlike the GSE’s, regional banks actually have to mark their assets to market and maintain reasonable capital reserves. After IndyMac was seized by federal regulators late Friday afternoon, the market’s attention turned to who might be next. Suffice it to say, no one is feeling optimistic about these guys right now.

So the latest in an increasingly long list of Federal bailouts has failed to calm the markets, and instead has just served to refocus people’s minds on what an expensive mess this credit crisis is turning out to be. This might not be a bad thing, if it prompted responsible adults to come together to work out an effective strategy for dealing with our problems and putting the economy back on solid footing. But this is an election year, and the silly season of half-baked policy proposals (gas tax holiday, anyone?) has already begun.

While Fannie and Freddie share some of the blame for letting the exuberant housing bubble to get out of hand (see Tanta over at Calculated Risk), it’s worth recalling that one of the first actions Congress took when the housing crisis started to get serious was to rewrite the rules so Fannie and Freddie could buy, securitize and guarantee many, many more mortgages. This was not a good plan for avoiding a taxpayer funded bailout, nor did it make life any easier for the GSE’s. As Tanta puts it:

“How do you go on a stock-selling binge at the same time you have just become the official lender of last resort (along with FHA), handed the mandate to take out all those toxic ARMs with too-large loan balances into "safe" 30-year fixed that the borrowers in question still can't afford? If credit risk wasn't, heretofore, mostly the GSEs' problems, it will be now.”

But really, the more substantial, long-term, structural problem that the United States needs to face up to is that it has been living beyond its means. As Martin Wolf reminded us the other day, it is the global financial imbalances – the US current account deficits and the corresponding surpluses of Asian and oil-exporting countries – that are the root cause of both the credit crisis and rising inflation. Over the past seven years, foreign central bank holdings of dollar reserves have increased by almost $5 trillion (of which nearly $1 trillion were Agency securities). The countries accumulating these reserves are the ones that have been explicitly pegging or managing their exchange rates against the dollar in order to maintain their export competitiveness. These capital flows acted as a sort of vendor financing scheme that financed the US trade deficit. For a short time, this seemed like a good deal for the US – we got cheap consumer goods, interest rates remained low and economic and employment growth remained strong even as inflation was contained. But now the bill to the US (and global) economy of these imbalances is coming to a head.

Basically, the US was being flooded with both cheap consumer goods and cheap capital. This led to a huge misallocation of capital. On the one hand, households went deep into debt, spurring a housing bubble that has now popped, which in turn caused a massive credit crisis that has shut down large parts of the financial markets and necessitated big government bailouts. On the other hand, the productive base of the US economy – the manufacturing sector, hemorrhaged jobs as companies shut down factories and moved jobs abroad. And it wasn’t some misguided public intervention in free markets that got us here. It was Wall Street.

It’s just too bad that now that we really need to invest in new productive assets – like new factories or even just fixing our crumbling infrastructure, our financial sector is in meltdown mode. But don’t expect Congress or the Bush Administration to come clean to the American people and lay out a strategy to fix the imbalances and allocate capital efficiently – this is an election year after all. We know what to do, we just the lack the political will to do it. I’ll leave the last word to Roubini…

From Roubini:

“the existence of GSEs....is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing – the most unproductive form of accumulation of capital – has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures.

The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt – by the household sector, the government and the country – to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger MacMansions through the tax system and the GSEs.

And these MacMansions and the broader sprawl of suburbian/exurban housing are now worth much less – in NPV terms – not only because of the housing bust and the fall in home prices but also because: a) the high oil and energy prices makes it outrageously expensive to heat those excessively big homes; b) households living in suburbian and exurban homes that are far from centers of work, business and production that are not served by public transportation are burdened with transportation costs that are becoming unsustainable given the high price of gasoline. So on top of the housing bust that will reduce home values by an average of 30% relative to peak high oil/energy prices make the same large homes in the far boonies of suburbia/exurbia worth even less – probably another 10% down – because of the cost of heating palatial MacMansions and because of the cost of traveling dozens of miles to get to work in gas guzzling SUVs. Thus, it is time to stop this destruction of national income and wealth that a cockamamie decades long policy of subsidizing the accumulation of wasteful and unproductive housing capital has caused....”