Tuesday, November 27, 2018

Housing: Part 333 - David Beckworth interviews Robert Kaplan

David Beckworth recently interviewed Robert Kaplan from the Dallas Federal Reserve Bank (transcript).  They discussed many interesting things regarding monetary policy.  There were a couple of items that I thought might be interesting to get into here.

Here is one spot:

Robert Kaplan: ...The nominal GDP targeting has a lot of appeal in that it takes into account inflation. It takes into account growth. The other thing is we are a very highly leveraged country. It's nominal GDP that services our debt.
David Beckworth: That's right.
Robert Kaplan: In other words, you need to generate nominal GDP to service the debt. There are some challenges though with this approach and others, which I actually would like to see us debate.
What's an example? How to explain nominal GDP targeting, in that there's a catch‑up mechanism in nominal GDP targeting and a lot of other aspects that I think are not going to be easy to communicate. The good news about the current framework is it's relatively straightforward to communicate.

This seems true, on the surface, but I think the more important point is that, in a way, NGDP targeting really wouldn't require communication.  How can I say that?  Well, what I'm thinking of is the countless conversations today about whether the Phillips Curve is useful, whether inflation trends will reverse or accelerate, whether expanding credit is feeding "overheating", etc.  Think of the millions of hours of debate and analysis that go into developing or forecasting Federal Reserve policy choices and their consequences.  The problem with the current dual mandate is that there is too much communication, and all the communication we could muster will never lead to consensus or certainty about near term economic activity.

With a functional nominal GDP targeting regime, there would be little to communicate.  And, what a relief that would be!

The following excerpt is more to the point of the focus of this blog - credit markets and the financial crisis.  As David points out, even this conversation would be less salient in an NGDP targeting world.  Management and regulation of credit markets wouldn't be so important if it wasn't an important ingredient in sudden negative NGDP shocks.  Kaplan's response to that notion is a window into the problem of seeing the housing bubble as a result of excess credit rather than a shortage of housing supply.

Robert Kaplan: If you look at the household sector in this country, the household sector was extremely leveraged. Meaning if you took household debt divided by gross domestic product for the households, there was a very high degree of leverage.
The reason we didn't notice it is if you looked at household debt relative to asset values, it actually didn't look excessive, back to home prices. What the housing crisis exposed is a lot of households were dramatically over‑leveraged, but they were comforted by the fact that there were easy mortgage conditions and home prices were very high.
Obviously, I don't need to remind people when the housing sector collapsed, all of a sudden, the household sector, it was clear, were very highly leveraged. They've spent the last eight or nine years deleveraging.
I think one of the lessons also, which relates to mortgage availability and so on, was we've got to watch the health of the household sector. Even with that, the aggressiveness on mortgage offerings were probably the tip of the iceberg.
It's all the securitizations upon securitizations upon securitizations of those mortgage obligations which magnified those excesses. If we didn't have all the securitizations on top of this aggressive mortgage lending, it still would have been painful, but it wouldn't have been anywhere near as painful as what ultimately happened.
David Beckworth: This goes back to the point you made earlier about nominal GDP targeting. Again, in a different world, a counterfactual world where we did have a nominal GDP level targeted, this would have made that crash a whole lot nicer or less severe.
Robert Kaplan: Truthfully, I wasn't at the Fed. I've been at the Fed only three years. I actually probably have a slightly different take. I think there's a number of things we do at the Fed. One of them is monetary policy, but another big one is macroprudential policy.
I think if you don't have good macroprudential policy, it's very difficult to run a sensible...It makes monetary policy harder. I think we need to do both. You could debate, and I've been part of those debates, to question monetary policy leading up to the crisis, approaches for monetary policy.
I think if you don't have good macroprudential policy for, again, stress testing, monitoring of the non‑bank financials, I think it makes it very hard to avoid instability.
David Beckworth: That's a fair point. If you did have those imbalances build up, let's say, for the sake of argument, you did have that leverage, I think the point you made earlier is that a nominal income target, a nominal GDP target that would make the unwinding of that leverage much more manageable. Is that fair?
Robert Kaplan: Listen, what I've learned is if the household sector gets over‑leveraged, you've got to accept it's going to take a number of years for households to deleverage. They're not like companies, who can sell assets, raise equity, restructure, restructure their debt. Households can't do that.
I think the trick is a little bit of prevention. I think we want to get into a situation where we monitor the household sector more carefully and try to take steps to maybe moderate excessive debt growth at the household sector relative to income. 

Kaplan's comments reflect what I think is considered an uncontroversial set of stipulations:
  • Excessive credit led to home prices and household debt that were bloated.
  • When home prices collapsed, households were left with the excessive debt.
  • Deleveraging from that debt slowed down the recovery.
The solutions to these stipulated risks are:
  • Prevent household debt from rising.
  • Prevent excessive use of multi-level securitizations and financial derivatives.
First, I'll point out a bit of a contradiction here.  Multi-level securitizations and credit default swaps on those securitizations were developed in order to create securitizations that didn't require new mortgages.  High household debt and excessive complex securitizations and derivatives are substitutes, not complements.  They didn't additively lead to a more acute crisis.  In fact, the rise of complex securitizations and mortgage-based derivatives came from having more savers looking for safe assets than there were investors taking the primary risk positions on either securitizations or home equity, itself.  The reason complex securitizations were profitable for their underwriters was because investors were willing to pay a premium for securities with lower expected risk.

I have discussed this many times, so I won't go into it here again in more detail, but this is an important, if subtle, correction to the credit-fueled bubble narrative.  Synthetic CDOs, CDO-squareds, etc. were the first stage of the bust, and they came about because the core cause of the bubble was a lack of housing supply, but the bubble was addressed as if it was due to a lack of fear.  Investors in the CDO AAA-securities were risk-averse.

Regarding the other points, what if high home prices are generally due to an urban supply shortage, and rising mortgage levels are a side-effect of that problem?  Then, what will happen as a result of the proposed solutions?
  • Home prices will remain somewhat elevated because of high rents.
  • Since credit is a side effect of high prices, there will be natural pressures pushing up demand for household debt.
  • To reduce that demand for household debt, taxes or non-price constraints will need to be implemented to reduce the quantity of household debt.
  • In order to keep household debt at a normal level as a percentage of income, debt will have to be held low as a percentage of home values and/or homeownership will have to be lowered.
  • Regulatory obstacles to home ownership will raise the yield on home equity - to some extent through lower prices and to some extent through higher rents.

So, the policy that seems like the prudent policy for the Federal Reserve to follow is a policy that will create high yields for a set of households who meet regulatory approval and that will create high costs for households who do not meet regulatory approval.  Over the past several years, this has been the case.  Using BEA data on housing value added and Fed data on mortgage and real estate values, the past few years have been unique in providing real returns on home equity that are higher than nominal yields on mortgages outstanding.

And, it is highly likely that regulatory approval will fall sharply along socio-economic status lines.

I am not arguing here that high debt levels are not systemically destabilizing.  I am not arguing that we shouldn't be concerned about them.  I am simply pointing out that the only realistic way to enforce this macroprudential policy is to enforce higher-than-market returns for select Americans while limiting access to those returns.  To be honest about that means being clear-eyed about the cause of high levels of household debt.

Or, to put this another way, there are many sources of value in an economy.  A marketable college degree creates value, in the form of human capital, but it is difficult to have liquid markets in human capital.  So, there isn't a ZillowPeople.com where you can see the current market value of college graduates and their current market wage.

Yet, in a way, housing sort of serves as a substitute for the market in human capital.  If a banker feels confident enough in your earning ability, she will allow you to take out a mortgage to commit to transferring some of the high wages you can earn to future payments.  The potential to foreclose on the house serves as a financial tool that facilitates this trade in human capital.  The banker serves as an intermediary, using the liquidity of the mortgage market and the stability of the housing market to facilitate trading activity in the human capital market.

That is what was happening before the crisis.  In most places, the mortgage and housing markets have developed to the point that more than 80% of households can complete that trade at some point in their lives.  This is a testament to the development of human capital (broad access to above-subsistence wages) and of real estate and mortgage markets.  But, our economy was hamstrung by a political limit to urbanization, which created a dichotomy: places that were exclusive and places that weren't.

That exclusivity is rationed through housing, and by happenstance there is a liquid market that measures the value of that exclusion.  There is a Zillow.com for houses.  Before the crisis, this trade in human capital and housing was still functioning, but in the Closed Access cities, this meant that only those with a large excess of human capital could engage in that trade.  They had to transfer a large stake in their future earnings over to the existing real estate owners to claim their place in exclusive labor markets.  In order to fully accrue the full potential of their human capital, they had to pay the toll to access the markets where wages were highest.

Home prices reflected the value of that exclusion, and homes traded at a value at reflected their claim on that earning power.  Certainly, the existence of these credit markets facilitated the market that revealed those values.

By focusing on credit as the cause of high prices, these transactions between human capital and the housing stock have been hobbled.  The undiscounted total value of future rents on properties has not been reduced.  "Macroprudential" management on mortgage markets has just added a significant premium to the discount rate that is applied to those future rental incomes.  This has lowered home prices in Closed Access markets from where they would have been, and it certainly has reduced household debt from where it would be in this Closed Access context.  But, because this is a misdiagnosis of the problem, where its effect has been the worst has been to block access to low tier housing markets in cities across the country that were never out of whack.  (I touched on this in the previous post.)

Macroprudential management has effectively been a step backwards to a less sophisticated economy, where access to ownership of real property requires a pre-existing stockpile of wealth, and those who have wealth earn higher returns on it.


  1. The more volatility you remove from the business cycle, the more leverage the system will add (it's the rational thing to do). This is essentially what happened in response to Greenspan's push for shorter recessions (which was akin to ngdp-targeting lite). So it's rational to add leverage yet we know there will always come a day when the Fed comes up short as many things can intervene with even the best plans (politics most notably). NGDP-targeting is a recipe for greater leverage and probably less-frequent crisis but of much greater magnitude. Of course economists can't ever seem to grasp feedback loops.

    1. Leverage requires a lender and a borrower. You are only considering the incentives of the borrower. A smooth business cycle will also change the incentives of lenders. For lenders, debt is an alternative to equity which avoids cyclical risk. Why would they choose to invest in debt instruments instead of equity instruments if they don't have to worry about cyclical risk?

      It is plausible that real interest rates will rise and leverage will be lower.

    2. And leverage by itself ain't bad. (It's only bad in a macro sense, if deleveraging leads to collapsing nominal GDP. But nominal GDP avoids exactly that.)

      But yeah, if you are worried about debt vs equity financing, a better lever would be change taxation. Right now returns on equity are taxed higher in most jurisdictions than interest payments.

      The next step would probably be to remove government support for deposit insurance. (And any implicit guarantees, too.)

    3. Yes. That's one of the frustrations about the central bank focusing on leverage. If leverage is bad, we should probably stop encouraging it in tax policy. To encourage it in tax policy and then to trigger economic contractions to try to minimalize it is not great.

    4. It's pretty simple: there is a very large bid for "safe assets" and equity will never fill that role. Obviously cash and govt bonds fill that role. However, what we see in leverage booms is that there becomes a large bid for things perceived as safe. If you take more volatility out of the business cycle I would predict that we'd see more of such behavior (packing instruments with tail risk as "safe") since we'd experience tail risks less frequently.

      I'm not saying that it's bad to take volatility out of the business cycle...just that it's unclear if there is any net gain. I don't perceive a net gain since Greenspan stepped in with the philosophy of "fight recessions early and aggressively" (again this is almost ngdp-targeting-lite)...but i can't know the couterfactual.

  2. What a great post. I am disappointed that David Beckworth did not explicitly mention housing supply---over and over again, we see the macroeconomics profession simply cannot address the idea that property zoning constrained supply plays a macroeconomic role in our nation.

    I also found interesting Kaplan's commentary that the US is highly leveraged. Other economists, such as Adair Turner and Robert Werner, have commented on the large fraction of commercial banking loans which are extended on extant real estate.

    It is not too much to say that it is largely through real estate lending that the endogenous money supply is expanded ( this is more true in Great Britain than in the United States ).

    A truly macroprudential policy would figure out how to expand the money supply but not only through the mechanism of commercial banking. A supplementary channel, so to speak.

    1. Too many economists are on the receiving end of high real estate values. I sense very little honesty from the profession on the topic. Economists should be spending a LOT of time talking about how to bring down housing, healthcare, education costs.

  3. 'compliments' should probably be 'complements'?

  4. KE (or anyone):

    You might get a kick out of this one:


  5. I think Kaplan is mistaken. A huge portion of our society won't understand either message (NGDPLT nor inflation targeting). And that's fine. Most Wall Streeters will understand NGDPLT well enough. If the Fed adopts it, they'll read the literature. Once you've read that, NGDPLT is easier to communicate.

    Household deleveraging. I think it's very mistaken. My understanding is that almost all the deleveraging that's happened with households has been foreclosures. Clearly it's not some painstaking process where we've had 10 years of monthly amortization to get LTVs in line with prices - prices are now near their peaks!

    Regarding LTV's and over-leveraging. We could stop having the taxpayer literally provide 95% to 100% LTV loans directly, right? FHA (I think they lend 97% of house cost plus closing costs which is about 100% of value?). If we really need to keep down leverage (I'm not sure we do, but if that's the goal), we could just cap it. Make it illegal to offer title insurance on any loan over 95% LTV.

    1. The Fed is a secondary problem here. They could have made it somewhat better with more inflation, but as you say, the deleveraging had a lot to do with foreclosures, which were the product of targeted credit repression that knocked 30% off of entry level home prices by adding a liquidity premium to the home equity market.