Monday, April 14, 2008
Fortunately, given the rate at which home prices are now declining in many parts of the country, any government action in support of home prices is likely to be far too little and far too late, but it doesn't stop people from asking the predictable question:
Should the government nationalize the mortgage lending industry or just monetize vast portions of the nation's housing market?
According to John Makin in this WSJ op-ed piece, it should by the latter. After all, the implied motto of the Federal Reserve over the last two decades has clearly been, "When in doubt, create more money".
The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the Federal Reserve to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street. If instead we let housing prices fall another 25%-30% – as predicted by the Case-Shiller Home Price Index – it's almost certain that Washington will end up nationalizing the mortgage business.Who would have thought that asset prices would produce an equal (or greater) amount of pain on the way down as they produced pleasure on the way up?
Fed reflation – to slow the fall in home prices and alleviate the distress for households and lenders – carries many risks. But the alternative is to struggle with a patchwork of inadequate efforts to shore up mortgage markets, while the Fed sticks to its current tactic of pegging the fed funds rate without increasing the money supply. This, I would submit, is even more risky. It risks a severe recession that will only intensify the drive for reregulation of financial and mortgage markets after the election.
Printing money is a radical step that enables the Fed to stop pegging the federal-funds rate and start increasing market liquidity directly.
While there is a substantial risk that inflation may rise for a time – this would be the policy goal – monetization is more easily reversible than nationalization of the mortgage market. Meanwhile, Fed officials concerned about inflation should rethink their view that it is impossible to identify an asset bubble before it bursts.
The postbubble period has yielded some very unattractive policy alternatives. They clearly underscore the rationale for having the Fed target asset prices – in a world where asset markets affect the real economy more than the real economy affects asset markets.