Paul Krugman on Fannie and Freddie

The way Laura Tyson puts it, a mortgage packager and guarantor is almost surely a good thing--but the GSEs should never have been privatized in the first place. Organizations with great government privilege are government responsibility--and there is no way in which they should ever have been let loose from oversight and made responsible to their private shareholders alone.

Paul Krugman:

Fannie, Freddie and You: And now we’ve reached the next stage of our seemingly never-ending financial crisis. This time Fannie Mae and Freddie Mac are in the headlines.... How worried should we be?...

Fannie and Freddie probably will need a government rescue. But since it’s already clear that that rescue will take place, their problems won’t take down the economy. Furthermore, while Fannie and Freddie are problematic... they aren’t responsible for the mess we’re in....

Fannie Mae — the Federal National Mortgage Association — was created in the 1930s to facilitate homeownership by buying mortgages from banks.... The case against Fannie and Freddie begins with their peculiar status: although they’re private companies with stockholders and profits... [with] privileges... [especially] the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue... profits are privatized but losses are socialized.....

Such one-way bets can encourage the taking of bad risks, because the downside is someone else’s problem.... But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago.... [W]hatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated... the Fannie-Freddie experience shows that regulation works.

In that case, however, how did they end up in trouble?... [T]he sheer scale of the housing bubble... a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines... [and they] haven’t been required to put up enough capital.... And yes, there is a real political scandal here: there have been repeated warnings that Fannie’s and Freddie’s thin capitalization posed risks to taxpayers, but the companies’ management bought off the political process, systematically hiring influential figures from both parties....

[L]et's be clear: Fannie and Freddie can’t be allowed to fail. With the collapse of subprime lending, they’re now more central than ever to the housing market, and the economy as a whole.

They cannot be allowed to collapse because we want to keep the economy near full employment, which means that construction-sector employment can't be allowed to fall faster than tradeable manufacturing-sector employment can rise. But they could be put into "conservatorship." And there is no reason that their stockholders need to emerge from this with any money at all.

Comments

[Jessica]

I do not see any reason either why the bond holders need to be made completely whole. Seems fair enough for them to share in the pain too. If that is where market mechanisms would lead.
And I must admit that it makes me suspicious when the pain to the shareholders is mentioned so often but the bond holders hardly at all.
And yes, the whole "Obama wants to tax you to fund Arab princes and Chinese communists" theme is the latest in wingnuttery. But that does not automatically mean that the exact opposite of whatever they want is the wisest and best policy.

If there is a case to be made that honoring _implicit_, _assumed_ guarantees (as opposed to explicit ones) is necessary for our well-being, I would ask someone to make it.

[Jessica]

Just to be more explicit: I think there is a fair amount of room between letting the GSEs fail and making their bond-holders 100% whole. And the fact that we need GSEs to act as guarantors for future mortages does not mean that we need to upgrade past securities from market priced ones (with a premium over Treasuries) to securities with a premium over Treasury plus government guarantees.

[Charles]

I agree with Jessica.

Let's start putting "monetary hazard" back into "moral hazard."

There's another point that should be stressed. Bad mortgages were added to Agency portfolios well after it was known there was a problem. People should go to jail for that.

[John Emerson]

The disgusting thing about this is: What are McCain and Obama talking about now? It would seem that a near-collapse of the US economy should be a political issue, but the campaigns are mumbling around about trivia.

The Straussians believe that public opinion should have only the most minimal influence of government policy, and so do technocrats, and so did Walter Lippmann. There are other theories of democracy than theirs, but we seem to have gone beyond them. Not only is democracy limited to choosing between elites every four years (and then shutting up), but even that minimal function has been more or less randomized.

[bakho]

Conservatorship would pull them back completely into the government sphere where they belong.

Privatization is a way for private companies to make big profits from public assets, until they hit hard times and the assets are returned to the public for a bailout. When will the rest of the public catch on that we are paying twice for our government services.

While we are at it, how about pulling back the private student loans and returning them to the government. Why should millionaires be allowed to gouge students who are trying to get an education??

[bakho]

"Ultimately I fear that one form of privatization does entail another--that as we move public provision into the private sector, we move from the realm of the open and visible into a domain that is more closed to scrutiny and access. And in the process, whether or not intending to change, we are likely to narrow our involvements, interests, and vision of a good society and a good life."-- Paul Starr, The Meaning of Privatization

http://www.princeton.edu/~starr/meaning.html

Twenty years later, it is still worth reading.

Is there any government function that should be privatized? What would be wrong with a campaign to make the word privatization toxic to any politician who uttered it?

Things that should NOT be privatized:
Social Security
Medicare D
Student Loans
Toll roads
Public Transportation
Post Office
NASA images
Charter Schools
Prisons
Utilities
Water
State and National Parks

[Anonymous]

Brad Delong is trained as a neoclassical economist, but I don't think I've ever read anything by a French state planner or an Austrian corporatist with such breathtaking certainty that state policy can fine-tune the allocation of productive resources:

"They cannot be allowed to collapse because we want to keep the economy near full employment, which means that construction-sector employment can't be allowed to fall faster than tradeable manufacturing-sector employment can rise."

In fact, I would guess that I would have to talk to someone who worked in the planning ministry for Khruschev, to find a similar certainty.

[No. You would have to talk to Ben Bernanke, Alan Greenspan, Paul Volcker, Hank Paulson, or Bob Rubin. This is what central banks do: they are islands of top-down central planning in the middle of what are otherwise largely market economies. They exist for Burkean reasons: they seem to work, we have them, and past attempts to move away from them have not gone well.]

One doesn't have to be a disciple of Hayek to consider the phrase "construction-sector employment can't be allowed to fall [...]" a breathtaking assertion.

And Delong is convinced that this can be achieved with *only* the most blunt of microeconomic tools - indeed almost a macroeconomic tool: trying to indirectly manipulate credit markets in order to incentivize private investment in a dead-end segment of the economy (the over-built residential construction sector) past the point when price signals are screaming 'stay away.' He believes that the incentives will align correctly (for both labor and capital) and without bottlenecks quickly enough that full employment can be sustained. The number of bizarre assumptions about the real economy that would have to be true for this to make sense is really, um, staggering. It is really hard to trick investors into paying the costs necessary to cushion structural adjustment. It is really stupid to use government money to subsidize private investors to pay the costs of cushioning structural adjustment (though if you lack the state capacity to do it directly and are ideologically incapable of developing it then I suppose Delong's plan is at least marginally more human than the Hayek/Mellon alternative).

This makes a proud addition to my list of things that are stupid in such a complex and interesting way that graduate training in economics is required to construct and hold them in the human mind.

And this man is among the best of policy-oriented economists. The people advising Paulson are much less intelligent (which may, admittedly, lead them to do less stupid things - or at least differently stupid). The Fed economists are not idiots, but they are learning what all central bank economists find themselves learning during a crisis: sometimes all the choices are bad and you just have to decide what groups you are more willing to impose costs upon.

All things considered, I rather wish that we had a few of the aforementioned French planners or Austrian corporatists to work on this problem...

[Phil P]

I find this part of Brad's post deeply disturbing:
"They cannot be allowed to collapse because we want to keep the economy near full employment, which means that construction-sector employment can't be allowed to fall faster than tradeable manufacturing-sector employment can rise." I agree they cannot be allowed to collapse, and yes, we want to keep the economy near full employment, if possible. And we want people to be able to get sound mortgages for existing homes, but surely we don't want to artificially prop up the construction sector and add to the inventory of unsold homes! One doesn't have to be an old-fashioned proponent of laissez-faire to suggest that an inability to tolerate any rise in unemployment, no matter how small or temporary, may do more harm then good.

[a]

Oh no, Fannie and Freddie can't be allowed to "collapse." Neither could Countrywide or Bear Stearns. Oh and Lehman - whose stock is down 7% today as I speak and at an 8-year low - that can't be allowed to collapse either. And the FDIC, which has lost about 10% of its reserves with Indymac's collapse alone, that will need to be saved too in a year or so. Of course.

We're destroying the economy in order to save it.

[baileyman]

Brad, your views are evolving, and improving. A few more days and you may come around!

[Altoid]

Am I the only person in the world who's thinking about the mortgage-based securities that these agencies create when they buy up original mortgages and repackage them?

Just this spring these things were dying. Banks all over the world were taking huge writeoffs on them. They're still doing it because these things are still problematic. And they're still a major class of financial assets, degraded though they may be. IMHO, saving these securities remains maybe the highest priority for the Fed and the Treasury.

The simplest way to do this is to pound on the federal guarantee and get it in writing if that's what it takes-- as in, the full faith and credit of the US government will stand behind foreign bank assets. I can see the point, given the logic of the situation. But I can't see where putting everybody's tax dollars into stock in these entities helps that process. That just seems like a gift to the wrong people.

[Sash]

Don't all these bailouts show that we need to develop policies which prevent any one firm from becoming too big to fail? Are the moral hazards really worth the supposed efficiencies created by having mega firms?

[Anonymous]

Professor Delong writes:

[No. You would have to talk to Ben Bernanke, Alan Greenspan, Paul Volcker, Hank Paulson, or Bob Rubin. This is what central banks do: they are islands of top-down central planning in the middle of what are otherwise largely market economies. They exist for Burkean reasons: they seem to work, we have them, and past attempts to move away from them have not gone well.]

Construction and housing are clearly over-invested. Put crudely, prices are dropping because there is too much supply for existing demand. You are advocating the use of very blunt monetary (and, one might infer from your statement, regulatory) instruments to subsidize continuing investment in housing construction until the economy shifts resources to (presumably) export competing industries and creates sufficient demand for labor to take up the slack created by job losses linked to the collapsing mortgage, residential building, and associated industries. This involves subsidizing and encouraging unproductive (or at least sub-optimal) investment, possibly *preventing* the very re-allocation of investment that you believe is necessary. Corporatist or statist thinkers would advocate the use of industrial policy or active labor market measures rather than monetary and credit-regulatory policies to achieve the same ends. Invoking those who support the use of monetary policy to smooth macroeconomic shocks to support an argument about sectoral adjustment is misleading.