classical economics
for analysis,  forecasting
and policy design

Sub-Prime Culprit
Consider The Federal Reserve
By Wayne Jett
© August 16, 2007

    The specter of sub-prime mortgage crisis looms across the land. Only last year, Americans owning homes reached record highs as unemployment remained below historic norms, and sub-prime mortgage lenders dished out home loans to borrowers with less than stellar credit performance. In early 2007, however, the lending environment changed rapidly. Easy loan standards of 2006 vanished as numerous sub-prime lenders collapsed or were acquired by larger firms at bargain prices. With the sudden turn of events, some sub-prime borrowers face foreclosure because they can’t make monthly loan payments.
    Fingers of blame search for directions to point, as usual, and have identified predatory lending practices that persuade lenders to borrow funds they can’t repay. But most lenders are keenly aware they lose money by making bad loans. A small percentage of loans involve fraud by borrower or lender, but that does not change much over time. To evoke such a radical change in the lending environment between 2006 and 2007, a macro variable must have been in play.
The Fed’s Responsibility
    Macro variables capable of producing cyclical change almost inevitably involve public policy, since most private monopoly power has been driven to extinction. The Federal Reserve System is a rare and significant exception. The Fed is a private entity given monopoly powers by Congress to issue and manage U. S. currency, and to regulate banks and other financial institutions. In managing the currency, the Fed is charged by Congress with maximizing employment consistent with price stability.
    That sounds like a big burden on the Fed, but is not. Society tends to be employed unless kept from it, and prices vary only with supply and demand so long as currency is honest. All the Fed has to do is issue currency that has measured, stable value. This being done, all who seek employment will have it, producing to satisfy demand, including their own. Prices signal needed adjustments of supply to demand. That leaves the Fed with a reasonably simple job: manage the currency so its unit value remains stable. Charge for doing so (sovereignage) and the Fed has a very profitable monopoly business with low risk of loss. That is a very enviable position for the Fed’s owners, who are the largest U. S. and foreign banks.
    But the Fed does not follow this business plan, and therein grow the roots of the sub-prime mortgage crisis. The Fed chooses to manage domestic interest rates rather than to keep the dollar’s value stable. The Fed calls the overnight funds rate target its sole instrument of monetary policy. The Fed hits the rate target by buying and selling U. S. Treasury securities in transactions with member banks. Doing so changes liquidity in the economy and allows, even causes, the dollar’s value to change moment-to-moment as other economic conditions affect demand for dollars to invest.
Perils of Managing Interest Rates
    Since the Fed began managing interest rates in 1971, the dollar has lost much of its purchasing value (about 95% relative to gold). A currency’s loss of purchasing power is inflation. Having caused the inflation by managing interest rates, the Fed says the cure for inflation is raising rates higher. That has not been the case, however, as Fed funds rate hikes slow economic growth, reduce demand for dollars to invest, and actually increase inflation as higher rates move the economy toward recession. All of this directly bears upon the individuals who are closest to the center of the bulls-eye in the Fed’s funds rate target: sub-prime borrowers.
    The Fed raises its funds rate target based on Phillips Curve theory that inflation rises as low unemployment increases leverage of workers in bargaining for higher wages. Fed chairman Ben S. Bernanke recently confirmed this remains the case, while expressing Fed thinking that steeper rate hikes may be required to stem inflation in the future due to relative inertia of “inflation expectations” in popular opinion. By the Fed’s approach, each funds rate hike is intended to produce a proportional increase in unemployment among workers at the margin in the economy. Guess who those marginal workers are: sub-prime borrowers.
    Sub-prime borrowers have below average credit records precisely because their employment is spotty, unreliable and/or low-paid. As unemployment edged below 4.5% during 2004-2006, these people enjoyed steadier income and more optimistic future prospects. With perhaps a little savings put aside and hopes for continued work, naturally such people reach to buy a home with the best available financing. Unfortunately for them, the Fed’s economic planning theorizes (wrongly) that monetary inflation will be retarded if these individuals lose their jobs. Based on that theory, between June, 2004, and June, 2006, the Fed increased the funds rate target from 1% to 5.25%. Banks and other lenders, including sub-prime lenders, use the overnight rate as the benchmark of setting their own rates for loans to customers. For example, banks charge their most credit worthy customers the “prime rate” (or prime plus 1%), which is the Fed funds rate plus 3%. Banks usually charge small and medium-sized businesses prime plus 2% or 3%, which presently is 10.25% to 11.25%. The total of 4.25% in rate hikes by the Fed in 2004-2006 presently drain an additional $180 billion per year from consumers and small businesses alone, leaving less capital available to support production and provide jobs to sub-prime borrowers.
    In 2004-2006, economic growth reduced the number of unemployed by 1,548,000, peaking in 2005 at 666,000 fewer jobless. But in 2007, the number of jobless has grown by 272,000 through July. That number of lost jobs corresponds reasonably well with rising defaults experienced in sub-prime mortgages. Remember, the sub-prime crisis flowed, not from a general “credit crunch,” but from (1) increase in defaults by sub-prime borrowers, and (2) anticipation of more defaults due to increased mortgage loan interest rates under adjustable mortgage terms. Both causes stem, at least in part, from Fed rate hikes. Eliminate the job losses caused by higher Fed rates and the mortgage rate adjustments based on Fed rate hikes and, almost certainly, the sub-prime mortgage crisis evaporates.
Why Continue Failed Policy?
    The Fed need not sacrifice sub-prime borrowers and other low income workers to fight inflation. Managing domestic interest rates is not an essential objective of any central bank. Attempting to do so inevitably causes deterioration of the currency, which then becomes the “reason” for raising unemployment. All this is avoided by Fed policy change to achieve stable currency value. John Maynard Keynes’ advice to manage domestic interest rates emanated from his conclusion that doing so would achieve a positive foreign trade balance, which he believed necessary to maintain prosperity. The Fed’s Bernanke now concedes Keynes erred in both respects, so no theoretical reason exists to continue managing interest rates. Then, why do it? A Fed policy change to target stable currency value cannot come too soon for sub-prime borrowers, whose hopes for economic success hang in the balance.
    With Federal Reserve theory having neither persuasive power nor historic success to recommend it, the Fed’s motives for targeting domestic interest rates are uncertain. Keynes advised managing domestic rates so as to remove them (and employment prospects) from “bankers’ whims.” Yet the Federal Reserve System is owned and operated by bankers, who influence the Fed and profit from it. Bankers understand implications of rising and falling interest rates relative to business profitability and asset prices. Thus, what banker would not covet a capability to predict – indeed, even to control – interest rates. Fortunes are made on knowledge alone of such macro-economic events. U. S. bankers sit astride a system authorized by federal law to manage interest rates, complete with power to create and destroy monetary liquidity. Mercantilists of the 15th Century could not dream of such an imposing position, so today’s bankers will not easily be dislodged from it.
Fixing Sub-prime (And Other Crises)
    Sub-prime borrowers are representatives of people worldwide who live near ground zero of the Fed’s funds rate target. Every central bank of smaller economies must follow the Fed’s lead in weakening its currency or else its producers are soon priced out of the dominant U. S. market. Global economic prospects, not to mention future American prosperity, depend upon achieving needed reforms of U. S. monetary policy. Otherwise, sub-prime lenders and borrowers will not pay the only price for its fatal flaws.
    On August 7, the FOMC kept its funds rate target at 5.25%. On August 10 and again August 16, the Fed injected liquidity, publicly announcing doing so “to facilitate the orderly functioning of financial markets.” Both actions were error. Better tactics under existing policy would have been to lower the funds rate and to forego liquidity injections. Injecting liquidity weakens the dollar further, since it provides no improvement in incentives to invest in production. Lowering the funds rate target, by contrast, allows faster economic growth, strengthening the dollar and allowing more subprime borrowers to keep jobs and pay mortgages. Ultimately, the superior solution is a dollar stabilized relative to gold by managing liquidity via the open market desk. ~