Monday, September 19, 2016

Socialized Gains and Privatized Losses

I think there is general consensus that the GSEs could be transitioned into a sort of public utility that issues guarantees on conventional mortgages.  The private/public setup was a mistake.  Back when it was set up, it made some sense, in that there was a need for a national entity with a capital base to provide a liquid market for mortgage securities.  Financial markets have matured a lot since then, and there really isn't much need for a capital bearing source of liquidity.  In an emergency, the Federal Reserve has now normalized the purchase of MBS as a monetary activity, so to the extent that emergency liquidity is useful, the Fed appears to be able to support the MBS market.

I think the Federal Reserve is actually the correct place for the GSE utility.  The guarantee function is really a purely monetary function.  The guarantee fees are a sort of seigniorage.  The utility could be run at a slight profit, much as current Fed operations are.  Occasionally, there might be a contraction so severe that the cost of those guarantees is more than the income.  In those cases, the Fed can open up its magic vault and pull out some cash.  It seems like this requires capital.  But, really, that idea is just a vestigial requirement related to private ownership.  Private firms don't have magic vaults.  If you think the GSEs need capital to fund their guarantee business, then just imagine that the Fed keeps a trillion dollar bill in that magic vault for "capital".

Having the guarantee business at the Fed also matches accountability and responsibility, since, really, if losses are so bad that the GSEs are taking them, something has gone wrong in the management of the national nominal economy.

One of the problems with the private/public setup was that, when public support for markets was most needed, the public was angry at financiers and profiteers.  The last thing they were going to stand for was some sort of public support that was going to boost the profits of shareholders.

This is a real public policy problem, because equity holders basically own systemic risk.  That is conceptually where all the excess returns of equity ownership come from.  Any public policy that serves to reduce systemic risk is going to, first and foremost, benefit equity holders.  In 2007 or 2008, if the Treasury had announced that they would stand by and promise to serve as a creditor to the GSEs, if necessary, and that they would encourage the GSEs to lend liberally in the meantime, while the Federal Reserve goosed the money supply to aim for 2% to 4% inflation until markets stabilized, they would have been pilloried for supporting the bankers that did this to us.

The only policy that would have provided stability was off limits because the public saw it as an example of privatized profits and socialized losses.  Yet, if the federal government had implemented those policies, there would not have been socialized losses.  It's plausible that not a single penny would have been required to support the GSEs if nominal support had been introduced in early 2008 or earlier.  The losses only came because there were a lack of policies for nominal stability.

Isn't it funny how much concern there is about privatized profits and socialized losses, yet nobody ever worries about socialized profits and privatized losses?

Think of President Obama's "You didn't build that." speech, or similar rhetorical justifications for marginal tax rates of 50% or more.  They are built on the reasonable idea that property rights, a function legal system, and infrastructure are dependent on a well-funded public sector.  These are socialized profits.

Privatized profits should be paired with privatized losses.

But, when losses are widespread.  When they engulf entire markets and industries, this is by definition a systemic, public issue.  In this case, losses should be socialized.  When this happens, shouldn't those who supported socialized profits be coming out of the woodwork to support social support for all those taxpayers who had been socializing their profits during the expansion?

Red: Effective Corporate Tax Rate
Green: Corporate profits as share of GDI
It's even worse than that.  Our tax policies on capital income are pro-cyclical.  When corporate incomes fall - an early indicator of economic contraction - our effective corporate tax rate goes up.  That is because our tax code specifically socializes profits and privatizes losses.  Most corporate losses have to be carried forward as write-offs against future profits.  In fact, the trigger that put the GSEs under their capital requirements when they were taken into conservatorship was the write off of tax assets.  Regulators said that future foreclosures would be so numerous that the GSEs were likely never to be profitable again in the near future, and so they would never be able write off future income taxes against their losses.  (And, yes, less than two weeks later, the Federal Reserve held the target rate at 2% the day after Lehman failed because they were worried about inflation at the same time the Treasury was expecting millions of future foreclosures.)

So, while everyone is worried about privatized profits and socialized losses, we have actually socialized profits and privatized losses, and I would argue that this was a primary cause of the crisis - much more important than underwriting in 2005.  We implemented trickle down economics.  We insisted on enforcing systemic losses, because those bankers did this to us and they had to pay.  And, wouldn't you know it, in 2009, there was an employment crisis.  If one didn't know better, you might almost believe there was some causality there.

It's almost like business cycle policy isn't about stability.  Imagine if home prices hadn't dropped by a quarter.  Especially imagine if home prices in low priced neighborhoods, hadn't dropped.  That was the most difficult part of the crisis.  It was really late 2008 and 2009 before we were able to knock low priced housing prices fully into submission.  A lot of privatized losses had to be created to do that - mostly by then in the form of lost home equity of working class homeowners.  We may be entering a secular age, but even a secular nation requires mortification of the flesh.


  1. Prior to reading this, I thought that the proper solution was to simply wind up the GSE's and let the market decide the proper allocation of capital to mortgage lending. This post is good food for thought. Thanks.