Macroeconomic Updates

Wadie Habiby (TEMBA ‘07) asked me to comment on the Administration’s attempted crackdown on the “checkbox” tax loop hole that allows US corporations to avoid paying taxes by shifting income to offshore subsidiaries.  Here are my thoughts (in the video below).  Please leave a comment and tell me what you think.

All the best,
M. Brandl

Permalink: http://blogs.mccombs.utexas.edu/brandl/2009/05/06/is-closing-tax-loopholes-just-the-start/

This past week the media is full of stories about the Swine Flu outbreak. What might be the impact for the macroeconomy? Here are my thoughts.

YouTube video at http://www.youtube.com/watch?v=_Jf65u1Apew

Today: April 21, 2009 Treasury Secretary Timothy Geithner is facing some tough questions on Capital Hill. But maybe the wrong questions are being asked…click on video below and then tell me what you think.

In order to post more periodically, this is the first of what I hope will be shorter, weekly video updates.

On Monday Treasury Secretary Timothy Geithner laid out his “Public-Private Investment Program” which is designed to buy up the toxic assets off banks’ balance sheet. The general idea is that Geithner does not want only the government to buy up these toxic assets because, in part, there is a fear that the government will overpay for them resulting in a huge windfall for banks.

So, to get around this thorny issue Geithner is creating up to 5 public-private investment funds that will bring together private entities (hedge funds, private equity funds, institutional investors, etc.) who will pony up some cash, which will be leveraged up to six times by the Fed, Treasury and FDIC to the tune of $500bn or maybe even up to $1trillion. These public-private funds would then buy up the bad loans and securities from the banks thus allowing the banks to clean up their balance sheets and hopefully start lending again.

Will it work? Well…here are some of the things to watch in the immediate future:

1) Will the banks sell? The plan assumes the banks will be willing to sell their legacy loans and securities to the newly created public-private entities. But will they? The original release of the plan says that the banks will decide which assets they will offer up for sale. But, what if the banks don’t like the price that is being offered? Will the banks be forced to sell the assets at the stated price? One could envision a game of cat-and-mouse where the banks refuse to be the first to sell their assets because they fear the price will increase in the future. Which brings up the issue:

2) How will the public-private partnership determine the price? Remember this is the problem that did in Paulson and Kashkari with the original structure of the TARP. Paulson and Kashkari couldn’t figure out how to price these exotic frozen assets and because they are so complex and non-standardized even if they could price some of them that does not mean they have set the price for all of the toxic assets.
Even if the new private-public partnership can solve this riddle and come up with prices on these assets it still faces the problem that if it pays too high of price, it is the U.S. taxpayer that is going be left paying the bill. On the other hand if the price they pay turns out to very low there will be huge profits to be made by the private investors who have used the government’s cash. This brings up the issue:

3) Will there be political fallout if this is profitable? What if the private entities do their job correctly: they buy the distressed assets at a bargain price and then sell the assets at a much higher price sometime in the not too distant future. Do you think you might see stories on 60 Minutes of how these fund managers “pocketed” millions of dollars by using taxpayer money and shifting almost all of the risk onto the taxpayers? Yikes, you can just sense the political backlash coming if this actually succeeds.

Which brings up the final question: is this the right way to do it?

A number of economists, including Martin Wolf at the FT, Willem Buiter of LSE who blogs at the FT, and Paul Romer of Stanford (and future Nobel Laureate) have been very critical of the entire plan. Their criticisms of Geithner’s plan range from its lack of recapitalizing the banks (Wolf), to not making the unsecured creditors of the banks suffer (Buiter), to a call for the closing of all of the “bad” banks and creating new healthy banks in their place(Romer).

For what it’s worth: I think they are right. I think Romer comes up with the best solution - essentially close down the insolvent institutions (no, it won’t trigger a system wide meltdown) and replace them with transparent, well run institutions that will start lending immediately. Those who work for the insolvent institutions might be able to find jobs in the new institutions…or maybe not. Depositors will be protected through FDIC and the government will initially provide the capital. Eventually they well morph into private banks, but under new ownership and management. Those who ran the failed institutions into the ground will be unemployed. That’s what should happen in competitive markets when you don’t do your job correctly.

Regards,
MBrandl

P.S. I will be giving free public talks at the following events. Please stop by and chat if you have the chance:

Friday March 27th from 1:15 - 2:15pm : McCombs Alumni Network’s 4th Annual Business Conference, AT&T Executive Education and Conference Center on UT campus. I will be discussing “Five Economic Concepts that Make Me Mad.”

Friday April 3rd from 7 - 7:55am (yes, that’s early): The Texas Executive MBA program and the Texas Evening MBA program info session, AT&T Amphitheatre in the AT&T Executive Education and Conference Center on UT campus. I will be discussing “An Update on the Current Economic Crisis.” Please contact Andrew Smith if you are interested in attending: Andrew.smith@mccombs.utexas.edu

Here are some things to think about in regard’s to the President’s speech to Congress on February 24th.

All the Best,
M. Brandl

Yesterday President Obama laid out his administration’s plan to stabilize the home mortgage market. Details of the plan are expected to be released on March 4th. Below is a summary of the plan, as well as the arguments in favor and against the plan. As usual I will try to present a non-partisan view of what is happening. I will let you decide who is right.

Based on what the Administration has laid out thus far (the quotes below come from the White House Executive summary of the plan), here are basics:

• $75billion for mortgage restructuring.

Designed to “reach millions of responsible homeowners who are struggling to afford their mortgage payments because of the current recession.”

Step 1: Lender has to lower interest rate on mortgage so that the borrowers’ monthly mortgage payment is no more than 38% of the monthly income.

Step 2: Further interest rate reductions would be matched dollar-for-dollar by the government to bring the mortgage payment/monthly income ratio down to 31%.

Step 3: That lower interest rate must be kept in place for 5 years, after which it could “gradually be stepped up to the conforming loan rate in place at time of the modification.”

Step 3A: the lender can also reduce the principle owed “with Treasury sharing in the costs.”

- The initiative will go only to “homeowners who commit to make payments to stay in their homes - it will not aid speculators or house flippers.”

• “Pay for Success” incentives to mortgage servicers:

a) $1,000 up front fee for each eligible modification
b) Fees paid by the government to the servicers as long as the borrower stays current: up to $1,000 a year for each year up to 3 years.

- $500 for servicers and $1,500 to mortgage holders if they modify at-risk mortgages before the borrower falls behind.
- Insurance fund: holders of modified mortgages would be provided additional payments if home prices continue to fall based on some “home price index.”

• Allow Judicial modification of home mortgages during bankruptcy for borrowers who have “run out of options.”

• Another $200 billion for Fannie Mae and Freddie Mac.

Those In Favor of the Homeowner Affordability and Stability Plan argue:

This plan uses incentives to encourage lenders and borrowers to restructure mortgages so that families can stay in their homes.

The plan also has the “stick” provision of empowering bankruptcy judges to rewrite mortgages. Thus, if lenders continue to refuse to play along, they could come face to face with an elected bankruptcy judge. The outcome of that meeting is something the lenders do not want to face.

The plan allows people, who have lost equity in their homes due to the financial crisis, to refinance their home mortgages at today’s very low interest rates. It always them to take advantage of the historically low interest rates and refinance their mortgages, even if they don’t have much equity or are even underwater on their current mortgage.

By preventing future foreclosures the plan is forward looking. It attempts to deal with not only those that are currently in trouble with their mortgages, but if offers assistance to those who might find themselves in trouble in the future.

The assistance will be provided only to those mortgages under the Fannie Mae and Freddie Mac limits. Thus, jumbo mortgages, those high priced mortgages provided to the wealthy are not going to get bailed out.

Those Against the Homeowner Affordability and Stability Plan argue:

The plan creates a huge moral hazard problem because it does nothing to punish those that took on excessive amounts of risk. Lenders who made bad mortgage loans and the speculators that now hold those mortgages are actually being given even more money to correct the mess they made.

By using tax dollars to refinance mortgages that people can not afford the plan is essentially a redistribution of money from those who were prudent (and paid taxes) to those who were reckless and sought a lifestyle they could not afford.

The plan does nothing to stimulate demand in the housing market. A major problem in the house market today is the glut of unsold homes. The plan does nothing to address this stumbling block on the road to recovery.

Things to watch:

One of the most controversial parts of the Plan (but it’s not talked about much in the media) is the potential change in bankruptcy law. This would be a major change. Watch the debate on this part of the Plan.

It will be interesting to see the details of how the Plan will ensure that it will not “aid speculators or house flippers.” What does that mean, exactly? Will there be some future equity surrender that will take place? And/or will this apply to only the primary residence mortgage? If so, how will that impact the “stabilization” of the mortgage market?

California and most of the Northeast is going to be left out of this due to the apparent exclusion of the Jumbo mortgages. Will Nancy Pelosi allow this? If not, what happens to the final price tag of the plan? Or will Obama be able to stick to the promise that this will help “average” Americans?

Here is an open letter to the President of the United States.

Dear President Obama,

After having watched your first new conference last night and having read Secretary Geithner’s speech this morning, please allow me to offer the following (non-partisan) economic policy advice:

1. Don’t try to scare the American people. Yes, we are currently in an economic slowdown and people are suffering. Yes, your stimulus package has a better chance of being successful if it is implemented quickly (more on that below). But, it is important to remember that much of our economic system functions on expectations. Modern day economists of all stripes (except the extreme few) believe that expectations play a major role in our macroeconomy. Thus, by consistently talking about “catastrophic” outcomes you are doing very little to increase confidence in consumers and businesses. This is not why you were elected. You were elected, in great part, because you gave millions of people “hope.” It is now time to extend that hope in an economic sense. Do so by explaining how your program will benefit people and the economy over the long run and potentially the short run. Do this, instead of trying to scare them into supporting your program. The latter is what the former administration did.

2. Understand why there is opposition to your stimulus package. Yes, there are some demagogues out there who will oppose anything you put forward. On the other hand, there are many who are justifiably concerned that massive increases in government spending must be paid for eventually. In addition, there are legitimate concerns that much of the money that goes to Washington is wasted. So respond to these criticisms by explaining how much of your spending plans (road, bridges, schools, etc) will more than pay for themselves in the long run. Also, explain in greater detail how increased transparency will help to ensure that federal government spending is not squander or obfuscated by the politically well connected. Further, explain how non-growth spending (increased unemployment compensation, aid to states, etc.) will be paid for in the future. If this spending is designed to “temporarily” boost the economy out of its slowdown, then how will it be withdrawn or paid for in the future? The financial markets and the American people, need to know massive government deficits will be controlled and not allowed risk our economic future through higher interest rates.

3. Understand that the drop is spending is a symptom of the current crisis not the cause. Remember that this economic downturn started because of the collapse in the mortgage market and that is where the cure must start. Once the mortgage market is stabilized and cash starts to flow back through those CDOs, then banks will start lending. When the banks start lending, then spending will increase, jobs will be created and we will move out of this recession. So the chain reaction needs to be: mortgage market-financial markets-spending. As you outlined in your press conference you understand the pieces, but I fear you have the sequence backwards.

4. Rethink Secretary Geithner’s plan. Secretary Geithner’s plan to “rescue” the financial system is confusing, a partial approach and does not address the chief problem, the mortgage market, in a serious manner. His plan does nothing to alter the incentives to ensure that we will not see a return the same behavior that got us into this mess. Instead, you should think more about ways to restructure bankruptcy laws to allow the courts to rewrite mortgages and “punish” those who speculated on real estate markets, while also offering financial help to those who have been duped by the system. Continuing the previous administration’s apparent approach to “save” the bankers and the banks is sure to result in even more financial stalemate. If Mr. Geithner is not up to the job, then replace him now. Paul Volcker would make a fine replacement.

I offer this advice to you in the sincere hope that your economic policies will prove to be successful for our economy and our people.

Best Wishes,
Mike Brandl

Here is (I hope) an objective analysis of the Administration’s fiscal stimulus package. I will leave it up to you to decide who is right.

First the facts:

As it stands now it will be about $820 billion of spending and tax cuts. More likely it will be closer to $900 billion. Here is a rough breakdown:

- $180 billion for extending jobless benefits and helping states with Medicare.

- $275 billion for tax cuts ($500 for individuals, $1,000 for couples, but capped around $100,000 income plus other tax changes)

- $140 billion on Infrastructure and Science (which includes school repair, broadband, parks, water resources, military housing, affordable housing, etc.)

- $125 billion on education and training (Pell Grants, state assistance for colleges, job training, etc)

- $51 billion on energy and energy conservation

- $25 billion on children and nutrition

- $16 billion on health research, treatment & prevention and Health IT.

- $ 8 billion for Small Business and Law Enforcement

This amount is more than the amount spent on the war in Iraq.

The Congressional Budget Office estimates that there will be another $347 billion needed to pay the interest for borrowing, so the total will be over $1 Trillion.

The Case for the Stimulus Package

Those in favor (including the Economist magazine) argue that during times of financial market collapses, fiscal stimulus is needed to, in the words of the Economist “counter the slump in private demand.” The argument is that there is simply too much uncertainty in financial markets right now and something needs to be done to increase the overall level of spending. Since banks won’t lend to finance household and business spending, government needs to step in and become the “source” of the spending.

Yes, the package represents a huge increase in government spending, but proponents argue, this must be put into perspective. According to Rogoff and Reinhart past financial market meltdowns have led to increased real public debt levels by more than 80% of GDP. Most of this rise in government debt came from the prolonged recessions that followed the financial meltdown.

Thus, a fiscal stimulus package is needed; it is argued, to keep the economy from slowing even further, thus increasing uncertainty even more, and thus making the financial crisis even worse.

Plus, governments can get themselves out of temporary large debt levels. As the Economist points out, during World War II Britain’s gross debt burden grew to 200% of GDP and the US debt was over 120% of GDP. But, in the post war years we saw neither run away inflation nor skyrocketing interest rates.

To delay and do too little, it is argued, would unnecessarily prolong the recession and wide up costing the taxpayer even more.

The Case Against the Stimulus Package

Those who question the usefulness of the Stimulus Package (including a long and sometime rambling, but popular piece from John Cochrane from University of Chicago or a much better source is pretty much anything written recently by Luigi Zingales also from Chicago) point out that the real problem with this economy is not that households don’t spend, rather it is that investors are avoiding risk.

The opponents of the stimulus package argue that it is the excessive amount of household spending (and lack of American savings) that is, in great part, to blame for this crisis. Thus, attempting to increase spending (yet again) would only cause more problems and not solve the real problem of the crisis. The real problem of the crisis, the opponents argue, is in financial markets.

Since the government does not have the $820 billion to spend on the stimulus package, opponents argue that the government must either 1) borrow more from domestic markets which would lead to LESS borrowing and spending by American households and firms or 2) borrow money from overseas, which seems unlikely without much higher interest rates due to the global economic slowdown. Either way, it is argued, this increase in government spending will necessitate a reduction in private spending.

There is also the issue of repaying the debt the government must create to pay for the stimulus package. Cochrane argues that there are only three ways the government repay this debt; 1) create inflation and reduce the real size of the debt, 2) raise taxes on future generations, which if people plan for the future would result in zero net impact on the economy right now, 3) the government defaults on its debt. None of the three are attractive options.

Instead the opponents argue more attention (and funds) should be directed toward stabilizing the financial markets. Zingales argues for debt for equity swaps for banks and for the splitting banks into two, one with “good” assets and one with “bad” assets. These can only be accomplished with significant changes in legislation and regulation.

What to Make of This

So will the Stimulus Package “work” as the proponent argue or is it just a bad idea focused on the “wrong” problem as the opponents argue? I will leave it up to you to decide, but here are some things to mull over:

Maybe, just maybe, the stimulus package isn’t really designed to be one. Almost all modern day macroeconomists (even the neo-Keynesians) have serious reservations about using fiscal policy to stimulate the economy in the short run. So maybe the idea is not simply to ramp up spending, but rather to inject “confidence” into the economy and financial markets. Here is what I mean:

To put it mildly, the American people are very angry. They see billions of their hard earned taxpayer money being flushed down the Wall Street toilet via the TARP. They wonder “why should Wall Street get massive amounts of taxpayer money, while ‘we’ only get pink slips at work?” I won’t even go into Citi’s corporate jet purchase or bonus payments being paid “talent” on Wall Street.

So maybe part of the point of the stimulus package is to try to show the American people that Washington is trying “to do something” for them not just the “fat cats” on Wall Street. The idea is to “buy” the public’s confidence through tax rebates to working and middle class, extended unemployment compensation, aid to the states, etc.

So is part of this a confidence game? Maybe, but certainly not all of it. Look closer at the numbers.

If you look at where most of the spending is going in the stimulus package, it is on things that won’t stimulate the economy in the short run, but they are things that will help the economy in the long run: physical infrastructure spending, education, worker retraining, alternative energy, etc. So what is the real objective of the stimulus package? Is it a short term boost to spending (maybe a little) or is the goal long term economic growth (a much better use of fiscal policy)?

Now, one has to be careful; these project must have a positive NPV and NOT be just more pork barrel spending. That might be the biggest challenge for the Obama Administration: make sure these new proposals actually result in net positive benefits for the public. Will he be able to keep his promise to “end” programs that are not successful?

It may be a very gusty move that results in a lot of wasted taxpayer money…or it may be brilliant.

It also has to be only the first step: now he has to tackle the financial market/mortgage market mess. Let us see what he comes up with for that.

All the best,
MBrandl