Housing Remedy: Employer of the Last Resort?

Financial Times columnist Wolfgang Munchau, in “Prepare for the credit crisis to spread,” tells us that the credit crunch is likely to get worse, since credit problems will spread to credit card receivables and car loans, both of which are typically securitized, and collateralized loan obligations (read takeover debt) also look shaky.

Munchau argues that central bankers aren’t likely to be able to respond effectively to this growing crisis, and the powers that be will have to resort to fiscal remedies. Citing academic research, he recommends that the government act as employer of the last resort. The logic is that the damage that people really care about in a recession is a loss of jobs, so the most effective response is for the government to provide work for those who want it but can’t find it elsewhere.

Munchau’s proposal has a certain elegance to it by virtue of directing dollars to the real source of pain. Nevertheless, I cannot see this country establishing a new Works Progress Administration in anything short of a full scale economic meltdown.

From the FT:

“Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

A Short History of Financial Euphoria, John Kenneth Galbraith

The late John Kenneth Galbraith would have enjoyed this summer. He was no expert on modern credit markets but his analysis of historic bubbles fits our most recent boom and bust episode with uncanny precision.

All historic bubbles were accompanied by a sharp rise in leverage. A salient feature of modern bubbles is the emergence of innovative financial products. No matter whether we are talking about junk bonds or modern collateralised debt obligations (CDOs), as Galbraith has pointed out, such products boil down to variants of debt secured on a real asset.

By historic standards, our credit bubble is probably one of the largest ever, given the sheer size of the market itself and the degree of euphoria that was characteristic in the final stages of the boom. While the fallout was initially concentrated in the financial sector itself, it would be surprising if the ongoing problems did not trickle down into the real economy. The availability of credit affects house prices and numerous studies have demonstrated the interlinkages between US house prices and US economic growth.

So what should central banks do? I suspect that central banks are not going to be the main actors in any rescue operation, but rather governments. Central banks’ room for manoeuvre to cut interest rates is more constrained this time than during the most recent recession. But more important, this is not the kind of crisis that can easily be stopped by a few hasty rate cuts or bank bail-outs. If your subprime mortgage exceeds the value of your house by 10 per cent, and if the monthly payments exceed your income, no positive interest rate could bail you out. Your only hope is some serious debt relief.

The economists Dimitri Papadimitriou, Greg Hannsgen and Gennaro Zezza last week published a study* in which they demonstrated the danger to US economic growth posed by the present real estate crisis. Their policy recommendations go significantly beyond the usual bail-out calls. They argue that it is almost impossible for policymakers to stop the decline in real estate prices, but “if the Fed and Congress can work to stop any incipient recession, they will prevent job losses, which are one of the main contributors to foreclosures. An effective job-creation method could be some form of employer-of-last-resort programme that offers government jobs to all workers who ask for them”.

We should remember that the subprime market is not the only unstable subsection of the credit market. Once US consumption slows, we should prepare for a crisis in credit card and car finance CDOs. And once corporate bankruptcies start to rise again as the cycle turns down, both in the US and in Europe, we will probably hear about problems with collateralised loan obligations. The credit market is very deep and offers significant potential for contagion.

In this sense, the debate about whether this is a liquidity or a solvency crisis is beside the point. Banks may look at their CDO investments as a source of temporary illiquidity, but may sooner or later realise that they are sitting on a pile of junk. The fiscal and monetary authorities should therefore assume that they are confronted with a solvency crisis. Bailing out the odd bank, as the Germans did last month, is not going to be sufficient and perhaps not even necessary.

Instead, the monetary and fiscal authorities should stand ready to support the economy if and when needed. Lower interest rates will probably be part of any such deal, but a large part of the help will invariably come from fiscal policy. The US Federal Reserve will probably cut interest rates soon and the European Central Bank will almost certainly postpone the rate rise it unwisely preannounced only a few weeks ago. I am convinced the next interest rate movement both in the US and the eurozone will be downwards.

One of the problems the monetary authorities have to deal with is moral hazard. This is not a theoretical issue, as some suggest, but a far more immediate concern. Moral hazard is the result of asymmetric expectations, as markets expect the central bank to bail out the financial sector during a time of crisis. The problem of moral hazard is to some extent related to the monetary policy strategy of central banks, with their mechanistic focus on a single consumer price index. Such strategies often have no space for asset prices, but markets know fully well that central banks must invariably take account of asset prices during sharp downturns. One way out of this asymmetry is for central banks to include asset prices into their policy frameworks in some form or other.

This said, a bail-out of the financial system will probably become unavoidable, but it should be accompanied with structural policy changes. Tighter financial regulation is probable. The role of the ratings agencies is bound to change too. And central banks should reconsider their monetary policy frameworks. They are part of the problem.

Print Friendly, PDF & Email


  1. Keith

    Excellent post (but very scary).
    The problem with addressing moral hazard is that you still end up having to trust the financial sector. Clearly this sector is out of control. In addition to Galbraith’s “emergence of innovative financial products” there has been a corresponding increase in middle men within the sector – to such an extent that the resultant purchaser of the debt has only the foggiest notion of its source and quality. Can you imagine for example what would happen if a auperannuant or other fund unit holder were to meet and get to know a sub-prime borrower ? Do you think the mortgage would still go ahead ?

  2. Anonymous

    Clearly also financial sector shareholders, who have benefited from from all the financial innovation are going to benefit from any action that prevents losses from falling through to equity. This also takes away their incentive to scrutinise the operations of the business.

    If this is to be the case, is it not more proper that the financial sector could pressed into the “Employer of the Last Resort” service. Sub prime mortgage holders, credit card debtors etc. as new employees will bring bankers et alia back face to face with their customers. The bankers would relearn credit risk assessment and relationship banking, the new employees about finance and the complexities of structured finance: all for the cost of a small structured finance operation. Shareholders would yield up enough earnings to make them more curious in the future.

    If only such fitting innovation were possible.

    The other alternative is to let losses fall through, allow financial sector players to fail no matter how big, and facilitate their purchase and recap, by new players as quicky as possible.

    Here this might be accompanied by temp modifications to permit personal bankcruptcy to have no/reduced impact on credit scores and to remove penalties over and above the individual losses from poor/insufficient judgement excercised in housing market.

  3. Keith

    If I were a manager of a bank I’m not sure I would want a sudden influx of employees who are under financial duress. You might as well employ people with a gambling addiction. I would just be happy if they didn’t retrench their existing staff (for a start).

    How’s this – if the ultimate purchasers of the debt derivatives have a less than hazy idea about what they’e bought, maybe the mortgagee could have a less then hazy idea about who to make repayments to, and stop.

  4. Dick

    The sub-prime mortgage home buyer problem is just the tip of the iceberg.

    Over the past several years millions of homeowners have refinanced their existing home to take advantage of lower interest rates. By pulling out equity their refinanced mortgage balance became closer to current market value at the time. Now that home prices have fallen significantly some mortgage owners can’t sell their home (pay off the loan) without coming up with the cash differential.

    Additionally, mortgage holders – primarily banks – are also sitting in a bad position as the home loan value on their books may be worth less than the property/asset.

    Now let’s add into the equation the strong possibility of an economic slowdown… jobs losses and salary/compensation cut-backs.

    Freezing interest rates for a ‘period of time’ will not cure the mortgage problem. If fact, it will most likely increase the size of the negative mortgage bubble. Individuals that are strapped for cash – especially the ability to pay their mortgage – will most likely not be in a better position a year or two from now. There is a very good chance these same consumers will accumulate even more debt.

    Credit card interest revenue is a huge part of a banks portfolio. Everyone knows banks issue credit cards to just about anyone. Bad debt was always factored into the interest rate banks charge customers.
    However, bank loan reserves are based on historical percentages of loans going bad. If the bank’s forecast for loan loses (reserves) are underestimated they simply increase the interest rate to make up the difference. However, raising interest rates too high only increases financial pressure on the credit card user. When this happens credit card users will often seek another financial institution with lower interest rates. In a tight credit market the consumer always looses.

    I say consumers that extended credit far beyond their means should learn from their foolishness. It is not the taxpayer that should be bailing them out… that means the government. Consumers must be made to learn from their foolishness… just as banks should pay the price for their greed.

    Where is it written in the constitution that our government should become mother & father to everyone?

  5. Ralph

    Wolfgang Munchau’s suggestion that we use “government as employer of last resort” (ELR) to deal with the recession is bunk. The way to deal with demand deficient unemployment is to raise demand: if necessary just print money.

    There IS a case for ELR, but the arguments as to exactly what form it should take are EXTREMELY complicated. Anyone who is not GENUINELY interested, just forget it. Go down to the pub and have a good time.

    For those genuinely interested, I’ve written several papers on the subject. For a brief introduction see http://employerlastresort.blogspot.com/2009/03/employer-of-last-resort.html

Comments are closed.