The Right Policy For Our Nation?

Since the shutdown and near collapse of two hedge funds managed by investment bank, Bear Stearns in August, the financial markets have been in chaos. These hedge funds invested in risky assets such as subprime mortgages that have rapidly lost billions of dollars of investors’ money. Further, without warning the public has been made aware that this situation was not isolated. Many other financial institutions and people made similar investments that have performed poorly. Not only the credit markets but also the housing and equity markets have performed poorly and are expected to continue to do so according to leading economists worldwide (Willis). Indeed, world leaders are seriously questioning whether a recession is in the American economy’s future and how best to act as to prevent one. Central bankers from not only the United States but the world’s other largest economies such as Japan, Germany, and the United Kingdom significantly impact every individual’s standard of living through monetary policy and must decide how to best respond to this financial crisis. Thus, the United States Federal Reserve must both act in response to these concerns immediately and also should act forcefully to prevent a recession by substantially lowering the federal funds rate.

The Fed must implement a change in monetary policy as soon as possible, because of three major reasons. They include “a credit market crisis, a decline in home prices and home building, and a reduction in consumer spending,” according to Martin Feldstein, president of the National Bureau of Economic Research (Feldstein). All of these factors pose the potential to seriously decrease economic growth in the United States. First of all, the Fed should respond to the credit crisis, because of the implied higher costs of credit that it poses in the future. The credit crisis refers to financial institutions flight from making investments in risky assets. Originally, these were subprime loans and other mortgage backed securities. Adjustable rate loans were made to borrowers with no or poor credit by mortgage brokers and in turn sold to other investors in large bundled packs (Kotkin).

However, many subprime borrowers recently have been unable to meet their required payments as rates increased above their initial levels. These defaults are more than what investors expected and have caused considerable distress (Feldstein). Investors literally were shocked in August upon the collapse of the Bear Stearns hedge funds and since then have been trying desperately to determine how to correctly price securities that invested in subprime mortgages. They have been unsuccessful and unable to sell these investments off. This is very significant, because hedge funds and private equity funds seriously increased the leverage used to purchase these loans by borrowing money themselves. In turn, the credit market has locked up and is unwilling to lend money to any borrowers who invest in risky assets (Seetharamdoo). This has prevented safe and normal borrowers of credit from receiving the loans they need to go about everyday business. Should the credit market continue to function incorrectly, the economy will grow at a decreased rate and slow any increase in our citizens’ living standards. Thus, the Fed must respond and improve the functioning of the credit markets in some way without delay.

Secondly, the United States Federal Reserve must implement a change in monetary policy as soon as possible, because a decline in home prices and construction will substantially aggravate the possibility of an economic downturn. Home building has experienced “about a 20 percent decline from last year to the lowest level in a decade” and the ripple effects are far from optimistic (Sarnoff). According to Economist Edward Leamer of UCLA, “Of the past 10 recessions, eight have been preceded by overinvestment and then a slump in housing” (Ip) Statistics such as this support the argument that housing is a critical driver of the economy. Further, home foreclosures have increased, because of the increase in mortgage defaults. These have resulted from owners with adjustable rate mortgages whose rates have jumped recently (Ip). Without a doubt, this increase is likely impacted by the large number of subprime mortgage holders. However, not only has home building declined, but also house prices are forecasted to fall 3.7% in 2007 (“Moody’s Forecasts”). Additionally, home prices are falling at their fastest rate in fourteen years (Nutting).

House prices could fall substantially further, because they “had been rising at unprecedented double-digit rates during the housing boom in 2003 to early 2006.” (Nutting). Should home prices decline in value more, to the point where the loans used to purchase the homes are worth less than the homes themselves, defaults may become even more of a problem. The result of this is standard macroeconomics 101. Once mortgage and home loan defaults become widespread, the supply of homes on the market increases and their prices decrease. As witnessed by the hedge fund fiasco, many financial institutions highly leveraged their investments in such assets. Thus, not only may the oversupply of homes and decline in home prices pose illiquidity problems, but also they “could become problems of insolvency” (Feldstein). In other words, while the housing market is illiquid right now and it is difficult to find buyers of many homes, current owners of homes’ loans and debt may exceed the value of their actual homes (Lanman). This would leave homeowners stuck with more liabilities than assets, tying up their ability to spend money at all. Quality of living would falter as people fight to merely maintain their standard of living. Therefore, in addition to the credit market crisis, federal policy must respond to this issue with urgency as to prevent further price deflation and home vacancies.

Thirdly, the decline of home prices and construction is important not only because it may cause additional declines in home building, but it also would decrease the wealth of American households and individuals nationwide. Thus, should a sizeable fall in house prices continue, it would substantially affect consumer spending. This is of even greater importance to the public intellectual, because consumer spending accounts for more than two thirds of the United State’s economy (Seetharamdoo). All that is needed to significantly decrease consumer spending and tip the United States into a recession is a decline in GDP or negative real economic growth, which would be caused by “a 20% cumulative fall in house prices” (Feldstein).

Additionally, the theory that mortgage refinancing plays a central role in consumer spending is gaining more and more ground. In March 2007, former United States Federal Reserve Chairman Alan Greenspan and Fed economist James Kennedy argued that “home equity served as a growing source of funds for American consumers from the early 1990s to 2005, when it financed close to 4% of total personal-consumption expenditures” (Blackstone). In other words, home owners use cash withdrawn from the equity of their homes as a source of wealth. This theorem suggests that the process of tapping into one’s home equity for funds contributes significantly to one’s consumer expenditure. An example of just how substantial this source of funding is offered by General Motor’s Vice Chairman Bob Lutz who believes that the mortgage industry meltdown has sharply reduced auto sales. “A lot of people are finding themselves in a position of reduced affordability and that has had an impact, not just on us, but across the industry,” Mr. Lutz told Reuters in April 2007 (“Moody’s Forecasts”). The government’s monetary policy plays a very strong role in determining whether or not consumer spending increases or decreases, because it sets such economic variables as interest rates. “The decline in home prices and rise in interest rates will shrink the future volume of mortgage equity withdrawals, causing consumer spending to decline” (Feldstein). This could push the economy into a recession if economic growth were to turn negative. Consequently, the U.S. Federal Reserve must respond soon as possible and prevent consumer spending from decreasing, by implementing economic policy that both prevents further drops in home prices and halts any future rises in interest rates.

The threats posed by turmoil in the credit markets, a decline of home prices and construction, and a reduction in consumer expenditure are all the more important, because of the connections that exist between them. All three scenarios are intrinsically linked to one another. Should the credit markets continue to not operate well, real estate will increasingly lose value and fewer homes will be built, while consumer expenditure will decrease. All three situations are being witnessed in the United State’s economy presently as mentioned by the examples above. Therefore, it is all the more dire that the United States addresses these issues soon as possible as to continue our economy’s expansion and ensure that the population’s well-being does not suffer but becomes better.

However, there are several alternatives the central bankers working for the Federal Reserve may implement as to respond to these risks. The Federal Reserve changes the direction of the economy through monetary policy, which is used to “promote ‘maximum’ sustainable output and employment and to promote ‘stable’ prices,” according to a 1977 amendment to the Federal Reserve Act (“US Monetary Policy”). While the Fed cannot directly affect inflation, unemployment, or output production it can affect them indirectly by changing the federal funds rate. It may be increased, decreased, or left alone and at varying magnitudes. Currently, the federal funds rate is 5.25%. This short term interest rate should be lowered greatly as to stimulate the economy and push it far away from future negative growth. Lowering the interest rates individuals, households and businesses are charged would lower their cost of borrowing, because they would then make smaller payments for their liabilities. This lower cost of extending credit would affect the economy in several ways that would help stem off a recession.

First of all, it would lower the cost of purchasing a home, because financing terms would be cheaper. The federal funds rate controls what interest rates banks and other financial lenders charge one another and their clients. So, if these short term interest rates were lowered, mortgages would require smaller loan payments to pay off balances. This would increase the demand for homes and cause home prices to move upwards preventing the downward spiral that home prices and home building is experiencing currently. Secondly, lowering interest rates “may increase banks' willingness to lend to businesses and households” and spur upward spending (“US Monetary Policy”). This would help prevent a significant decline in the economy output, because of the large portion that consumer expenditure contributes to gross domestic product. In particular, individuals like you and me would increase our spending, because the majority of us receive lines of credit primarily only from banks. Thirdly, if interest rates are lowered, the equity markets will perform better increasing the prices of stocks and other investments. If borrowing becomes cheaper for businesses, they generate higher future cash flows and the value of their businesses moves in the same direction: upwards. Fourthly, lowering interest rates will decrease the value of the dollar and increase the number of US exports to other countries. This will increase the total amount of spending on goods and services produced here in our country. Lastly, if interest rates are lowered, the increased demand for output produced in the US will fuel greater business investment and spending (“US Monetary Policy”).

All of these cause effect relationships affect the economy in positive ways. However, it must be emphasized that lowering the federal funds rate is a short term move and not long term. If the US Federal Reserve lowered interest rates forever, expansion would continue for a longer period at the expense of inflation and capacity. Lowering interest rates fuels inflation, because it decreases the real purchasing power of an individual. Additionally, should the country’s economic resources be used to their full extent the economy will over extend its capacity. However, at this point in time, fears of a recession are more pressing and urgent issues than inflation, because of the credit market crisis, a decline in home prices, and a reduction in consumer spending. Therefore, due to the severity of these imminent recession inducing factors, the United States Federal Reserve must act immediately and should lower the federal funds rate. To not do so would be to ignore our population’s right to a continuously improving quality of life.


Works Cited

Blackstone, Brian. “Greenspan Sees Spending Link to Home Equity.” 24 Apr 2007. 12 Sep 2007

Feldstein, Martin. “Liquidate Now!” 12 Sep 2007. 13 Sep 2007

Felsenthal, Mark, and Bull, Alister. “U.S. at risk of recession from housing.” 1 Sep 2007. 12 Sep 2007

Ip, Greg. “Should the Fed Target Housing?” 31 Aug 2007. 12 Sep 2007

Kotkin, Stephen. “Dangers of a Turbocharged economy.” 2 Sep 2007. 11 Sep 2007

Lanman, Scott. “Feldstein Warns of U.S. Recession.” 2 Sep 2007. 11 Sep 2007

“Moody’s Forecasts 3.6% Median House Price Decline in 2007.” 05 Oct 2006. 13 Sep 2007

Nutting, Rex. “Home prices fall at fastest rate in 14 years.” 27 Feb 2007. 11 Sep 2007

Nutting, Rex. “What will send the U.S. into recession?” 7 Sep 2007. 10 Sep 2007

Sarnoff, Nancy. “A Cloudy Forecast for Home Building: First Decline 13 Years Could Have Ripple Effect.” 27 Jun 2007. 12 Sep 2007

Seetharamdoo, Julien. “What if the US consumer stops spending?” 12 Sep 2007

“The Big Picture | More on Mortgage Equity Withdrawals.” 24 Apr 2007. 11 Sep 2007

“US Monetary Policy: The Fed’s Goals.” 11 Sep 2007

Willis, Bob, and Chandra, Shobhana. “US Economy: Confidence Wanes, House Prices Decline.” 27 Mar 2007. 12 Sep 2007