Wednesday, October 08, 2008

From Where Does Economic Policy Come?

Unlike the VP Debate, I sat through most of last night’s Presidential Debate, walking away from the TV only for a few minutes in total when I found it especially hard to take what the candidates were spewing out and only a couple of times in the entire 90 minutes session. While I persisted in the watching, for the most part I was underwhelmed. The candidates mostly stuck to their scripts from the campaign, rather than come up with new things that might help in the current crisis. Obama was better putting the narrative to his prior held positions and making a coherent argument. McCain seems to be all over the place. But truthfully I think the election is over, not because of who McCain is, but rather because no Republican could win in this climate.

McCain did come up with a new idea. He didn’t generate it. The idea is attributed to economists Martin Feldstein and R. Glenn Hubbard. It’s based on the notion, something I agree with, that for those troubled mortgages where the property represents the primary residence of the occupant that the efficient social allocation is for the residents to remain in the property rather than have the property repossessed. With that as a starting point, the next thing to observe is that the in many cases the face value of the mortgage now substantially exceeds the property value. That is the classic condition for when default by the homeowner is rational. So to avoid default and keep the current owners in the house, the right thing to do is renegotiate down the face value of the loan. Sounds like a good idea – in theory.

Now a personal story to try to illustrate some issues with the idea. In our prior house, which we bought in 1990 and were the first occupants to live in it at that location, determining the market value of the house was a bit of a sticky wicket. The house was an old Victorian from a town called Villa Grove, about 20 miles from Champaign. (In the map, B is where we lived, southwest of Champaign, while A is from where the house came.) After the house was moved it was renovated at the new location. We saw it only after it had been finished. It was a little bit out of our price range at the time, but we fell in love with it – beautiful interior woodwork, very high ceilings, a lot of charm to the place. The house was in a small community of other Victorian homes that had been similarly moved from other locations and renovated at the new site. The new location was in the middle of corn fields – 8 of these houses out there in the boonies, each of them with a unique character. We originally looked at a house next door that ultimately one of the developers inhabited. Only upon seeing that one did we find the one we bought.

The problem was how to price the place. It was one of a kind – essentially no comparables. When the house was appraised for our mortgage, the appraisal came in exactly at the price we had negotiated with the seller. I read the appraisal and since there was a requirement that an appraisal have the price of three comparable properties included, there were 3 properties listed with their latest transaction price. I don’t remember what those properties were but I do remember feeling that these were substantially irrelevant, that either the transaction was more than a year old, the property was not close to ours geographically, or the houses themselves were too dissimilar. If the appraisal is an entirely independent valuation of the house, the probability is nil that it will come in at exactly the negotiated price. In our case, the appraisal was clearly just a necessary document so the bank could make the loan, without conveying much if any additional information.

I believe we’re in essentially the same boat for these properties financed by sub prime mortgages. We know the property values have fallen due to the bursting of the housing market bubble. But we don’t know what current property values really are and there isn’t a good market test for that because that market has essentially dried up. The immediate alternative to the current owners living in the house is not occupancy by some other family. Rather it is leaving the house unoccupied so the holder of the mortgage can ultimately resell the property at some unspecified time in the future when a buyer can be identified. In this climate if the Government is to renegotiate the loans, then the obvious question is to what size and how do they come up with that? As we all know, the devil is in the details, and of course those details have not yet been discussed. If they were, my guess is that the plan would look like the Government is imposing price controls on housing. It may eventually come to that, but note that was not mentioned by McCain in the debate.

* * * * *

Tom Brokaw, the moderator of the debate, did ask both candidates whom they would choose to be Secretary of the Treasury. They both artfully dodged the question since the true answer is that it will be determined by a negotiation that will occur only after the election has been held and we have a new President-elect. Brokaw, of course, knows this but he was also right to ask the question because people are quite anxious now and want to understand how the course of economic policy in the future will be determined. But I think Brokaw’s question should have been modified to the title of my post, for the following reason.

We’ve had two Secretaries of Defense under President Bush, Rumsfeld and Gates. Rumsfeld, along with Vice President Cheney, was clearly a policy maker. The policies were flawed, to be sure, but here I’m asking about attributing authorship, not about the qualities of the policies themselves. Gates, in contrast, is more of an implementation guy. He was brought in to get things done after gridlock had been reached at the Defense Department and clean up the mess that had been created. One could have a Secretary of the Treasury who is a policy guy, or the person could be more an implementation guy with the policy determined elsewhere. The President-elect could be making those policies himself, based on advice he receives from his economic advisors, those formally part of his Council of Economic Advisors, and others to whom he listens who are not in named positions. But what sort of policies will they be? I thought David Brooks raised the right sort of issues in his column yesterday:

In his astonishingly prescient book, “The World Is Curved: Hidden Dangers to the Global Economy,” David M. Smick argues that we have inherited an impressive global economic system. It, with the U.S. as the hub, has produced unprecedented levels of global prosperity. But it has now spun wildly out of control. It can’t be fixed with the shock and awe of a $700 billion rescue package, Smick says. The fundamental architecture needs to be reformed.

It will take, he suggests, a global leadership class that can answer essential questions: How much leverage should be allowed? Can we preserve the development model in which certain nations pile up giant reserves and park them in the U.S.?

These questions definitely need to be answered. But, further, the answers have to be tied back to what the candidates have been saying about the reforms they want to institute. Does doing one mean chucking the other? I don’t know. That’s the question that needs to be worked through. The candidates have not sketched a picture about what 21st century regulation of the financial industry looks like, contenting themselves to lambaste the current system. So we in the electorate are in the dark on this score. That’s why I found the debate so uninspiring.

The news today about a coordinated (across many large and important nations) monetary policy response to the credit crunch suggests a move to an oligarchic and global solution to monetary policy, which seems right given the interconnectedness of the capital markets. Perhaps we also need to rethink the separateness of fiscal and monetary policy, assured in our country by the independence of the Federal Reserve System, historically a good idea so that monetary policy would be outside the domain of the political business cycle. Could it be that fiscal policy as well should be moving outside the domain of national politics because of the interconnectedness of the markets? Energy policy, in particular, might lead the way on this.

The rhetoric in the Presidential Campaign on economics issues is essentially entirely domestic, with the exception of the discussion of jobs being shipped overseas. In discussing the bailout the last couple of weeks, there was little or no discussion about the impact of the proposal on markets elsewhere. We need a new rhetoric to talk about policy that has global consequence and we need to move away from the unilateralism in conceptualizing our problems. I find the rhetoric about America being #1 especially unhelpful in this regard. The rhetoric needs to be about a community of nations acting in concert. We have a long way to go to get to that. Unfortunately, it seems that if a candidate talked this way it would be characterized as weakness rather than as strength. Obama has talked this way about our military involvement Iraq, Afghanistan, and the Middle East. Our rhetoric has international matters conceived as mostly a military issue. We don’t talk of them in economic terms.

I wonder whether the economics profession as a whole might address this and that a bunch of ideas bubble up which get embraced by the politicians. It’s far easier for this to happen with tactical ideas, renegotiating the size of extant mortgages, than it is for this to happen at more strategic policy level. And there is a counter force to doing this that needs to be met square on – the interconnectedness tends to equalize wages on a global basis. The Presidential election is now being reframed as how best to stabilize the incomes of the middle class, for example, this piece by Bob Herbert. Obama had a similar refrain we he talked about energy efficient automobiles made in America rather than in Japan or South Korea. Statements like this have visceral appeal. But it is a rhetoric of competition, not of collaboration, and it treats origin of production as an entitlement rather than as determined by comparative advantage. The rhetoric of competition, unfortunately, will keep fiscal policy in the political domain.

We’ve got a lot of thinking to do ahead of us.

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