Restoring U.S. Financial Markets in a Credible Way: Comments on Feldstein and Yellen

January 27, 2011

From January 6-9, I participated in the annual ASSA (Allied Social Science Associations) conference in Denver, Colorado.  I was part of a high-level panel discussion with a number of distinguished economists including Janet Yellen, the Federal Reserve’s Vice-Chair; Martin Feldstein, of Harvard University; Andrew Brimmer, former Governor of the Federal Reserve Board; and Alan Krueger, former Assistant Secretary for Economic Policy, among others.The discussion focused on the economic policies undertaken during the Obama administration. Perhaps the most interesting presentations on these issues were given by Yellen and Feldstein. Here I briefly summarize their main points and the comments that I delivered during the panel discussion.First, Janet Yellen spoke about the rationale behind the Fed’s program of asset purchases, better known as QE2 (the second round of quantitative easing that involves purchases of Treasuries in order to bring down long term interest rates, which has been hotly contested), and its economic and financial effects. Since the announcement of QE2, the central policy question concerning this program has been whether or not it has lowered interest rates and thus had a stimulating impact on the economy. Interestingly, Yellen argued that it has, and she pointed to the fact that after the announcement of QE2 in November and then again in December, the yield on the ten year treasury decreased. However, yields then increased after the announcement of the Obama stimulus plan on December 6. The verdict is that without QE2, long term interest rates would have been even higher.

Martin Feldstein made comments on the Home Affordable Modification Program, the government’s plan to restructure mortgages as a response to the crisis. This program allows eligible borrowers to lower their monthly payments to 31 percent of their pre-tax income (or lower) by having their interest rates reduced. He noted that the problem with this plan is that, even when the interest rate is reduced, the principal amount is not. As a result, many homeowners have chosen to default because the outstanding value of the mortgage is greater than the value of the house itself. Feldstein argued that the government should focus on stocks instead of flows; specifically, the government should work with lenders and homeowners to reduce the principal amount of the mortgages of people whose loan-to-value ratios’ are greater than 120%, given that these homeowners are likely to default. He proposes a voluntary government program where both banks and the government would share mortgage restructuring costs by reducing the loan-to-value ratio to at least 120 percent.
As a discussant with both Feldstein and Yellen, I was extremely happy to hear Martin Feldstein’s remarks focusing on a proposal to deal with the problems in the mortgage market since, in my view, the unsolved problems in the mortgage market and the associated “debt overhang” in households’ portfolios wealth is acting as a severe constraint on the effectiveness of the recent stance of monetary policy, well described by Janet Yellen. What I have learned from my long experience in advising and studying financial crises around the world is that countries get back on a sustained growth path only when they fully resolve their financial sector problems in a credible way.  This is especially important in the case of the United States, where, albeit at a lower rate, consumption still represents approximately 70 percent of GDP.  Thus, as long as consumers are burdened with excess debt on their mortgages, borrowing will not revive and therefore credit will not expand substantially.I believe QE2 is an almost heroic attempt by the Fed to fill a gap left by Congress and the government, who have not finished the most pressing task to sustain the recovery: cleaning up banks’ balance sheets from bad debt and putting in place a full restructuring program for Fannie Mae and Freddie Mac. Although I think that the Fed is fully aware of the constraints on the effectiveness of monetary policy imposed by unresolved financial issues, I also believe that the Fed’s pursuance of its current policy reflects its intention to send a clear message that it will always be ready to act to support an economic recovery. In spite of any unintended consequences, as Janet Yellen noted in her presentation, QE2 has helped to increase prices in the stock market, thereby bolstering households’ wealth.On a related note, during my presentation I also highlighted the implications of recent US economic policies for developing economies. As I mention in a recent paper, the excess liquidity created by QE2 in combination with a low interest rate environment has led to many emerging market countries’ economies being flooded with funds directed at purchasing various assets, including government bonds and equities. This raises the concern of a potential creation of asset bubbles in these economies, as well as the risk of a rapid currency appreciation, and a consequent decline in international competitiveness, especially in countries with deep financial markets such as Brazil and South Africa.I also noted that China’s policy of not allowing the yuan to appreciate faster worsens this situation since the appreciation pressures are being absorbed by the capital recipient countries that have more flexible exchange rates, among which many are in the developing world.In my opinion, an adequate solution to the problems hampering a US recovery that can also mitigate risks for emerging market countries lies more in the adequate implementation of fiscal policy and increased efforts in financial regulation than in further expansionary monetary policy. While the US does have a sovereign debt problem, it still has time on its side. Indeed, investors’ concerns over the Eurozone crisis will most likely result in an increased demand for US Treasury bonds in 2011. This provides valuable time for US policymakers to reinitiate the debate on how to effectively use fiscal measures to solve once and for all the debt-overhang problem in the mortgage market.


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