MM goes mainstream

I was listening to some speakers on Bloomberg discussing the Malaysian and Chinese credit markets, and this comment (by David Stubbs) caught my attention:

Default cycles tend to come when you get that weaker nominal GDP and certainly when expectations of nominal GDP are not met—indeed the expectations that were embedded in the lending contracts themselves, which drove the credit expansion.

Bank in 2009, this argument was viewed as borderline “crackpot”.  I was told that it was “obvious” that the debt problems were due to reckless subprime mortgages, highly leveraged banks like Lehman and irresponsible Greek deficit spending, and that falling nominal GDP was the result.  Now the heterodox (market monetarist) view seems to be going mainstream.

 


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31 Responses to “MM goes mainstream”

  1. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    19. April 2016 at 08:10

    >A slightly off-center perspective on monetary problems

    Maybe time to change?

  2. Gravatar of ssumner ssumner
    19. April 2016 at 08:52

    Wasshoi, I hope so!

  3. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 09:12

    I think it makes perfect sense Scott. But then you have Fed researchers like Christopher Phelan saying that the Fed fears a run on itself. For Phelan, if the banks all rushed to pull excess reserves out in order to then lend at 10 to 1 into the real economy, it would create a disaster. So, he even fears the possibility that the Fed could not raise IOR rates at all in an inflationary scenario. That does not bode well for negative IOR. http://www.talkmarkets.com/content/economics–politics-education/federal-reserve-mandates-slow-growth-so-fed-must-finance-american-infrastructure?post=91756&uid=4798

  4. Gravatar of james elizondo james elizondo
    19. April 2016 at 09:31

    So what’s Brad Delong talking about then?

    http://www.bradford-delong.com/2016/04/the-disappearance-of-monetarism.html

  5. Gravatar of Kevin Erdmann Kevin Erdmann
    19. April 2016 at 09:34

    Scott, here is a post I did on this. Expectations caused the housing bust. Read the S&P report at the end of the post. This was basically the first round of downgrades in mid 2007. Even then, they were perplexed because borrower characteristics had no explanatory power on the early defaults. The first downgrades were made because they forecasted that home prices would decline e at epic unprecedented rates, even though home prices at the time had just begun to falter.
    But everyone was so convinced that it was a credit bubble, they assumed that the reason underwriting wasn’t predictive was because it was so fraudulent. That is simply not credible. And the Fed’s response to these downgrades was basically to announce that we should definitely expect home prices to collapse and that they wouldn’t do a think to stabilize it. In fact they were worried about inflation (much like sept. 2008 a year later). To this day Bernanke talks about how they figured home prices were due for a drop and whatareyagonnado? And everyone nods. Yep. It was bound to happen.
    Expectations caused the housing bust.
    http://idiosyncraticwhisk.blogspot.com/2016/01/housing-series-part-107-brief-review-of.html

  6. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 09:55

    Well, you could get a mortgage if you could fog a mirror in the latter stages of the housing bubble. That is still true. But after the Subprime fiasco of mid 2007, helocs were then pulled in mid 2008. I think that really screwed with the money supply but someone could look into it. I think Steven Williamson agrees with that. The Fed mispriced risk, and that made securitization work. And securitization froze up. So, you can’t say there was no credit crisis. There was a destruction of the commercial paper market as the chart here shows: http://www.talkmarkets.com/content/bonds/proof-the-federal-reserve-was-responsible-for-the-housing-bubble-and-crash?post=89477

    Still, the Fed did nothing for over a year and then jobs were lost in non bubble areas. So there is truth the the MM claim for sure. But to say there was no credit crisis when securitization ended, drying up access to credit, is kind of wrong.

  7. Gravatar of Dan W. Dan W.
    19. April 2016 at 10:06

    Glad to know the experts have figured out how to solve yesterday’s problem. It only took them 7 years! Should that bolster confidence or scare one silly?

  8. Gravatar of TallDave TallDave
    19. April 2016 at 10:29

    We’ll see how BoJ does. BoK is probably watching, seems to still be following price stability.

  9. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 10:30

    I have no doubt Wall Street wanted the houses back, Kevin. They had MERS all set up, and they had a plan from the beginning, IMO, to get the houses back. They knew securitization would not last forever. They knew it was based upon mispriced risk. They just had to work out the process of fleecing America. It was a process, and probably the Fed forecasted lower home values because that was part of the process too.

  10. Gravatar of ssumner ssumner
    19. April 2016 at 10:42

    James, All explained in my new post.

    Kevin, I applaud them for not focusing on housing prices, but unfortunately they also failed to look at the thing they should look at—NGDP.

    Gary, You said:

    “But to say there was no credit crisis when securitization ended, drying up access to credit, is kind of wrong.”

    It would be, if anyone had said that.

    Dan, Maybe the real “experts” are those who knew seven years ago. 🙂

  11. Gravatar of Kevin Erdmann Kevin Erdmann
    19. April 2016 at 11:10

    That’s all well and good. Call it NGDP expectations if you like. The point is lowered expectations happened before the housing bust happened. You might even say that since everyone knew a housing bust was inevitable, the Fed’s question was how far would they have to let NGDP go in order to stop the faux bubble. The problem is that, since there was not a housing demand bubble, but instead a housing supply bust that predated the demand bust, NGDP wouldn’t go down because the collapsing homebuilding market meant rent inflation shot up.

    I recall someone saying once that recessions begin before the thing that caused them occurs. The first shoe to drop in this recession was that the NGDP drop in 2008 caused home prices to collapse in 2007. The reason it happened this way is because the federal government had clamped down on the GSEs in 2003 and 2004, pushing mortgages into private securitizations where systemic default risk would affect the market price of the bonds. This was not a risk under GSE funding.

    One of the ideas I am developing in the book is that rent inflation in the Closed Access cities isn’t really inflation. It’s a transfer of rents created by arbitrary limits to capital. I think this may apply to both inflation targeting and NGDP targeting. When a large enough portion of economic activity is a product of arbitrary barriers to entry, the target inflation or NGDP rate needs to be higher.

    It has commonly been thought that credit expansion made Americans feel wealthier than they were. But, I contend that the increased value of real estate in the boom was a reflection of economic stress and expense. Working Americans felt less wealthy because most of that real estate value reflected the value of rents we expect Closed Access landlords and homeowners to extract. The high real estate values reflected a cost to productive residents, similar to extractive taxes paid to a king. This meant that all nominal measures of economic activity were overstated, including NGDP, although NGDP targeting certainly would have improved policy.

  12. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 11:16

    “I recall someone saying once that recessions begin before the thing that caused them occurs. The first shoe to drop in this recession was that the NGDP drop in 2008 caused home prices to collapse in 2007. The reason it happened this way is because the federal government had clamped down on the GSEs in 2003 and 2004, pushing mortgages into private securitizations where systemic default risk would affect the market price of the bonds. This was not a risk under GSE funding.”

    Fascinating statement, Kevin, but chilling in its condemnation of the Fed’s predetermining the course of events.

  13. Gravatar of Dan W. Dan W.
    19. April 2016 at 11:19

    Kevin,

    Was there a housing supply bust in Las Vegas or in the California Inland Empire? Those houses were built and than sat empty for 5+ years! There was a ready supply of homes. Just no one willing to buy them.

  14. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 11:45

    This is from the Stanford Study and you guys might be interested. I used it for my article. It makes sense if you look at the commercial paper chart by Fred:

    The vast majority of repos were collateralized by safe government securities, they say, not riskier securitized mortgage products. So while the ‘run on repo’ may have contributed to the problems of a few repo borrowers that were relying heavily on repo with riskier collateral, in general, “the ‘run on repo’ was a sideshow,” Nagel said.

    Instead, much of the short-term funding for securitized mortgage products, and the bulk of its contraction during the crisis took place in the asset-backed commercial paper market. According to Nagel, the risk of backing those assets was largely borne by commercial banks, which helps explain how solvency problems moved from the shadow banking system into the regular banking sector.

    Many commercial banks took a page from Enron’s playbook and created special purpose vehicles that allowed the banks to keep risky assets on the balance sheets of the vehicles instead of on their own, Nagel said. As a result, it was difficult for investors or regulators to know that the banks still effectively bore the risk of these securities.

    But when those securities went bad the vehicles could no longer find buyers for their commercial paper. At that point, the poisoned assets migrated to the balance sheets of the commercial banks, depleting their capital, moving the bad debt from the shadow banking system — the vehicles are part of it — to the conventional banking system.

    https://www.gsb.stanford.edu/insights/role-repo-financial-crisis

  15. Gravatar of Kevin Erdmann Kevin Erdmann
    19. April 2016 at 12:08

    Dan W., a demand bust happened after the supply bust. You’re describing the demand bust. The supply bust was centered in Coastal California and New England, which is where most of the increased real estate value was located before 2005. The demand bust happened after 2005 and was nationwide. It continues today.
    Florida, Arizona, and Nevada had a brief bubble, if you want to call it that, in 2004 and 2005. But this was a small portion of the total real estate market and was anomalous. It also was related to sharp increases in out-migration to those states from the places with supply busts. In those 3 states, real estate values briefly rose and then crashed. This did not happen in 90% of the country.

  16. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 12:18

    Inflation adjusted house prices were bubblicious, nationwide. And I am not talking about bubble gum. How do you explain the first chart at this link, Kevin? http://www.jparsons.net/housingbubble/

  17. Gravatar of Maurizio Maurizio
    19. April 2016 at 12:37

    “I was told that it was “obvious” that the debt problems were due to reckless subprime mortgages”

    If the debt problems *were* due to reckless subprime mortgages, how would you tell?

    I mean: in the MM framework, is there a place for the concept of “bad loan”? How do you recognize them?

  18. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 12:46

    Maurizio, market monetarists are right about NGDP. They are dead wrong about there being not much of a housing bubble.

    They may not all agree there wasn’t much of a housing bubble. Depends on which MM you ask.

  19. Gravatar of Ilya Ilya
    19. April 2016 at 13:42

    Scott,

    Have you ever gone into detail as to the precise mechanism of why collapses in NGDP and their expectations causes bank crises? I’ve tried searching your blog but I find it difficult to get specifics.

    Is it Irving Fisher’s Debt Deflation theory?

  20. Gravatar of Benjamin Cole Benjamin Cole
    19. April 2016 at 16:17

    Scott- kudos to you and others who have brought Market Monetarism front and center. Sadly, I must note that at the last Jackson Hole central banker confab there were four panel presentations, all on the topic of inflation. To my knowledge, the Fed has never had an official presentation about Market Monetarism.

    To all: Kevin Erdmann is well worth reading.

  21. Gravatar of Gary Anderson Gary Anderson
    19. April 2016 at 17:12

    Kevin is worth reading, especially about closed access cities. He should put away his error that there was no housing bubble, Ben. Why would he be fixated on something that simply is not true? Even closed access cities saw areas of decline, once credit was no longer available.

    Credit was no longer available for two reasons:

    1. There was a run on the money markets and bad MBS collateral affected credit.

    2. Even bigger, SIVs (off balance sheet vehicles) began to fail in their purpose of selling commercial paper that backed the shadow banking lending market, causing bad loans to be forced onto the TBTF bank balance sheets, causing the commercial paper market to implode. That was the big washout of credit.

    You would have thought that with the destruction of GDP and of credit, the Fed would have done something. But it didn’t. This is where I agree with the Market Monetarists.

  22. Gravatar of derivs derivs
    20. April 2016 at 02:35

    “the debt problems were due to reckless subprime mortgages, highly leveraged banks like Lehman…..”

    “Default cycles tend to come when you get that weaker nominal GDP and certainly when expectations of nominal GDP are not met”

    Both seem to me to be acceptable reasons exclusive of the other, or even both occurring simultaneously, but does not have to be one OR the other.

    “Even then, they were perplexed because borrower characteristics had no explanatory power on the early defaults.”

    Shouldn’t be perplexed. Smart money always enters and leaves first. Of course the first to default should be the guy who sees that he can walk into a non recourse state, put down 1-3%, and take the free put (no one saw – or valued) embedded in the mortgage contract and buy houses like they were free calls. Price goes below the strike and you exercise the put by walking away….

    “I have no doubt Wall Street wanted the houses back, Kevin. ”

    Gary, I assure you they did not.

  23. Gravatar of Ben Ben
    20. April 2016 at 03:34

    They issue money ahead of wealth creation then when it doesn’t come we have the inevitable contraction.

    How does issuing more to paper over the cracks help? Stop private money issuance and introduce land value tax. Get people earning money who are doing actual work not creating fiat money.

  24. Gravatar of Gary Anderson Gary Anderson
    20. April 2016 at 06:08

    I said banks wanted their houses back. But Scott says they didn’t. Unfortunately, they did want them back. Mers made it easy. It ran roughshod over county rules. Servicers got PAID TO FORECLOSE, NOT TO MODIFY, SCOTT. Check out this article at the end of the article:

    http://www.dailyfinance.com/2011/01/20/whos-to-blame-for-the-mortgage-mess-banks-not-homeowners/

  25. Gravatar of Gary Anderson Gary Anderson
    20. April 2016 at 08:48

    Sorry, Derivs said they didn’t want the houses back. I don’t know what Scott thinks. Derivs read that article at Daily Finance.

  26. Gravatar of ssumner ssumner
    21. April 2016 at 06:36

    Kevin, I don’t think that monetary policy had much effect on housing until 2008.

    Maurizio, Here’s how you’d tell. You’d have a monetary policy that kept NGDP growth stable. Then actual defaults would be evidence of bad loans.

    Ilya, Less nominal income makes it harder to repay nominal debt. Debt defaults lead to bank failures.

  27. Gravatar of Ilya Ilya
    21. April 2016 at 10:11

    Thanks for the response Scott.

    Do you have evidence showing that the collpase of NGDP in the summer and fall of 2008 caused a wave of defaults between june and october 2008 on debt owed by the public which directly was attributed to the collpase of Lehman brothers and the other banks in the fall of 2008?

  28. Gravatar of Maurizio Maurizio
    21. April 2016 at 11:06

    “Maurizio, Here’s how you’d tell. You’d have a monetary policy that kept NGDP growth stable. Then actual defaults would be evidence of bad loans.”

    So in the absence of stable NGDP there is no way to tell a bad loan. Very interesting.

  29. Gravatar of ssumner ssumner
    22. April 2016 at 06:36

    Ilya, All I can say is that if you look back over history, whenever a tight money policy leads to a big fall in NGDP, you tend to get debt crises. And also that economic theory predicts that a big fall in NGDP would lead to debt crises. So you have solid theory, and correlation in the empirical data, but I have nothing more specific for the US.

    Maurizio, You said:

    “So in the absence of stable NGDP there is no way to tell a bad loan. Very interesting.”

    I never said that. Read what you asked me, and what I said.

  30. Gravatar of Ilya Ilya
    22. April 2016 at 14:22

    Scott,

    But then this is the most important question that must be answered. You must develop a research program and find this evidence. And let’s say this evidence cannot be found and does not exist. Then doesn’t that mean your theory is false? This is the key piece of evidence that must be uncovered to prove your detractors false.

  31. Gravatar of ssumner ssumner
    23. April 2016 at 08:41

    Ilya, I’d say we have lots of evidence, but could always use more. Just to reiterate:

    1. There are theoretical models that suggest financial crises are less likely when NGDP growth is stable.

    2. Empirically, financial crises tend to occur when NGDP growth falls sharply.

    We’d like more, but that evidence is far more than Keynesianism has going for it, and Keynesianism is a widely accepted theory.

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