ECON204 Lecture Notes - Lecture 6: Liquidity Trap, Deflation, Monetary Policy

Let's change it up a little. You may have to dig a little for this one. Fannie Mae and Freddie Mac are two banking giants that have been in news because of their role in the 2008 financial crisis. Due to this many in the government believe that the two companies should be put out of business. On the other hand, there are many who believe the companies should remain as they are. See The Case For Keeping Fannie and Freddie Alive. The argument both ways is in a sales pitch for the two contrary opinions. how would you convince someone either way on the issue of Fannie and Freddie? A reference is required to support your post

On just one major piece of economic policy, President Obama and House Republicans share the same basic opinion: kill off government-backed mortgage giants Fannie Mae and Freddie Mac.

This rare bit of consensus might also prove to be a devastating mistake.

Fannie and Freddie which guarantee mortgages were placed under federal conservatorship in 2008 as the housing bust reached its apex. The firms are roughly within $42 billion of repaying the $187.5 billion they received from taxpayers, but Obama and much of Congress plan to wind them down in the belief that another federal bailout will never again be necessary.

We can't leave taxpayers on the hook for irresponsibility or bad decisions by some of these lenders or Fannie Mae or Freddie Mac,€ Obama said in a speech this month. We've got to encourage the pursuit of profit, but the era of expecting a bailout after you pursue your profit and you don't manage your risk well, that puts the whole country at risk. And we're ending those days. We're not going to do that anymore.€

But the political debate has been lopsided thus far focused on putting Fannie and Freddie into the grave, while largely ignoring what their demise could mean for homebuyers and the economy a sharp jump in interest rates, and a drop in the availability of mortgages.

Senate Majority Leader Harry Reid (D-NV) has objected to plans to end both companies.

These are the government organizations that have made homeownership so easy, Reid recently told Nevada Public Radio. I don't agree with the president. He says he wants to get rid of them. I'm going to look closely at his recommendations because on their face, I don't like them.

Mostly, economists and investors are framing the issue in the same way as Reid.

It boils down to a tradeoff between shifting risk away from the government and taxpayers, versus keeping mortgages inexpensive and widely available, said Jed Kolko, the chief economist at the real estate firm Trulia. When push comes to shove, it's hard to do both.

Their executives received outlandish bonuses during the boom, only to foist the eventual losses caused by years of mismanagement onto the public. It rightfully enables sucker punches from Capitol Hill that voters approve of, even though the rescue kept the entire housing sector alive. Of the $1.75 trillion worth of mortgages originated last year, about 90 percent were made through the federal government.

This point matters because Fannie and Freddie ensure that the housing market does not seize up during a recession, said Ken Fears, an economist for the National Association of Realtors. Even if more private capital is needed in the mortgage industry, having the government participation creates liquidity€ that keeps the entire sector operating during tough economic times, Fears said.

Lawmakers tend to assume that the markets can transition over five or 10 years to a mortgage industry with a modest government backstop, or no taxpayer support at all. Before retiring at the end of May as a managing director for bond investor PIMCO, Scott Simon said that this amounted to a fantasy.

The private market can make mortgages, but they would trade at much higher yields and the down payments would be much higher because the private market cannot make competitive, fixed-rate mortgages with 20% or less of a down payment on the loans, Simon told National Mortgage News. Most of the people who think we should shut [the GSEs] down have a pure philosophical belief and they don't care what the outcome is. Or they simply don't understand anything about how housing finance works.

Fannie and Freddie help the economy with their guarantees, Simon reasoned but exposed taxpayers to their risks by having their own investment portfolios.

As of now, all profits from both companies go to the Treasury Department, per changes made last year to the terms of the conservatorship. In the original terms, Treasury received a 10 percent dividend from Fannie and Freddie. But Fannie and Freddie are now required to fork over all of their earnings forever to Treasury, a windfall that suddenly reduced the budget deficit.

A group of investors led by the hedge fund Perry Capital challenged this arrangement in a U.S. District Court lawsuit filed last month, claiming that they deserve a share of the proceeds after taxpayers have been repaid.

Because Fannie and Freddie are now generating cash, it would in theory be possible for the government to use these profits to create a capital cushion that prevents the need for a future taxpayer bailout.

By keeping the two companies under government control, taxpayers would benefit from the sale of about $200 billion worth of equity, investors in Fannie, Freddie, and other real estate assets explained in the background. The profits would be enough to create a capital cushion to insulate against a future downturn, without having to seek capital in the private market that could push mortgage interest rates higher.

But this requires Obama and GOP lawmakers to save Fannie and Freddie, precisely what they have vowed not to do. Obama wants a government insurance fund to replace them, while Republican congressmen favor an end to any Washington involvement with guarantees.

House Financial Services Committee Chairman Jeb Hensarling (R-TX) would eliminate almost all federal involvement in the mortgage market. His policy assumes that the rusty tin standard of 30-year, fixed-rate mortgages would soon fade away, as more homebuyers would settle for variable-rate mortgages. Interest rates on a 30-year, fixed mortgage currently average 4.4 percent, a figure that could instead swing violently over time depending on inflation and the Federal Reserve. When the Fed attempted to tamp down inflation between 1980 and 1982, rates soared above 16 percent with the government backstop in place.

Obama would like to preserve the 30-year, fixed-rate mortgage. He has endorsed adopting a more limited government backstop as outlined in a bipartisan Senate bill co-sponsored by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner.

The Corker-Warner bill would also unwind Fannie and Freddie, bringing their dominance to an end. In their place would be private financial institutions that would pay into a government insurance fund. Mark Zandi, the chief economist for Moody's Analytics, estimated that the plan would cause mortgage rates to increase by as much as 1.25 percent in the near-term. This estimate assumes a 20 percent down payment and a credit score of 750, slightly above the current U.S. average.

But of course, lawmakers have not discussed the potential tradeoffs in the early stages of mortgage reform. Unless voters have a clearer picture of the consequences, some say it could produce the same kind of boondoggle caused by Obamacare in 2010.

I don't think there has been much of a sales job to the public on what a new mortgage finance system looks like,€ said Brian Gardner, senior vice president of Washington research at the investment bank Keefe, Bruyette & Woods. I don't think you shove this down the throat of the electorate, as we saw with the health care overhaul.

Hello, could you please assist with this discussion question for the Economics course? Thank you.

5) Go to the internet and find an article that discusses the problems of income inequality in the U.S. economy, summarize key points, and post in the Discussions area.

http://neweconomics.org/2014/12/why-inequality-is-an-economic-problem/

Why Inequality Is An Economic Problem

Rising economic inequality was a major driver of the financial crisis. With the OECD recently debunking ‘trickle-down’ economics, our new report sets out the links between inequality, the growth in scale and influence of the financial sector, and the dangers for financial stability.

A fragile recovery

A return to growth in economies such as the UK and USA has been welcomed as a sign of recovery from the 2008 financial crisis. But as GDP picks up, so too has the widening gap between rich and poor.

The crisis may be over for the wealthy but the aftermath for ordinary workers depressed wages and growing debt is only getting worse.

Most nations have mustered only negligible growth and this has failed to benefit the vast majority of those nation's populations.

In the seven years following the crash, the UK has suffered the longest sustained decline in real wages since records began.

This decline hasn't has been shared equally across the income spectrum latest annual data up to the end of 2013 shows real earnings for the top 10% increasing by 3.9% and a 2.4% fall for the remaining 90%.

Households are once again piling on risky personal debt at a rate of almost $1billion a year.

Globally, wealth grew by 8.3% last year to $263 trillion, even as living standards stagnate for the majority. Income inequality has seen a sharp return the top 1% of earners have reaped 95% of the USA's economic gains since the crash.

Inequality increases as economies are financialised

Over the past four decades, financial sectors have been extensively deregulated and have expanded enormously as a result, particularly in the UK and USA.

This deregulation produced two systemic outcomes: finance has been freed to become the motor of the economy while the pursuit of greater equality of citizens, as was the focus after the second world war, has been abandoned.

Instead, the notion that unrestrained pursuit of wealth would trickle-down from rich to the poor has been embraced in the mainstream political and economic arenas.

Financial markets, products, and firms now play a much larger role in many areas; from pensions and social insurance to homes and public infrastructure.

Privatization and the doctrine of maximizing value for shareholders have increased the amount of economic activity focused on extracting the largest possible short-term profit. These trends are referred to collectively as ‘financialisation’.

Until now the connections between this increasing prevalence of financial activities and the steady increase in economic inequality have not been clear. But when these two trends reached a boiling point in the mid-2000s they fuelled a global collapse of financial systems.

The polarization of wealth and incomes fed asset bubbles, risky financial activity,, and necessitated vast levels of household debt – resulting in the 2008 financial crash. With little done since to address these interconnected drivers, the threat of another crisis is very real.

This diagram lays out the seven indicators of economic instability, each fuelled by rising inequality and increasing financial sector activity:

Our report describes how these indicators laid the path for the 2008 crash, and threaten to do the same again:

Increasing inequality depresses demand since consumption levels depend more on the wages of those at the lower end of the income scale than the profits of the wealthy

In the face of stagnating wages, households rely increasingly on debt to maintain their lifestyles with rising asset prices, especially in residential housing, worsening this.

Financial liberalization allows money to flood into countries with trade deficits, such as the USA and the UK, providing the funds for debt-led consumption.

Snowballing wealth at the top increases risky financial speculation.

Inequality doesn't bring growth, it brings economic instability

In recent years there has been a marked slowing of growth across the world's wealthiest economies, with none returning to the growth trends experienced before the crisis. Many have begun to speculate that this stagnation could, in fact, be a permanent development meaning that wealthy economies are fundamentally unable to create enough demand to keep growing.

The mainstream political consensus has for decades now suggested that inequality is a price worth paying for economic growth.

But new research from the Organisation for Economic Co-operation and Development (OECD) shows definitively that this inequality/growth trade-off is false adding to a growing body of research showing that inequality actually prevents economies from growing. This points to a fundamental structural flaw in the economy: if the proceeds of growth are not shared, the pie stops growing.

The pursuit of higher returns for the already wealthy within this dwindling pie cannot persist forever. With wealth refusing year on year to trickle down, debt has been used to plug the wage-consumption gap for the rest.

The signals are showing quite plainly that this pursuit of growth, via inequality, is ineffective and unsustainable.