Unintended Consequences

As the US economy continues to slide, the pressure for the government to take charge becomes ever bigger.  The consensus seems to be throwing the kitchen sink at the problem.  We are now talking about a $1 trillion stimulus package, fed funds rate at 0%, complete regulatory overhaul of the financial industry, and a healthcare system reboot, among other less dramatic measures.  With such drastic increase of the role of the government, the opportunity to make mistakes is proportionally larger.  Somewhere in this frenzy, some of these well-intentioned policies will go wrong, perhaps terribly wrong.  We can already see signs of this.  Take, for example, a couple of points from the Obama economic plan. 

A. “Foreclosure Moratorium:” Obama’s plan has called for prohibiting banks that receive federal bailout money from foreclosing on homeowners who are making “good-faith” efforts on their mortgage payments.  The theory is that to arrest the decline of the economy, we have to save housing first.  What better way to save housing than to stop foreclosures?

Unfortunately, the thinking is misguided.  If anything, it is likely to extend the length of the housing price downturn.  If banks can no longer foreclose on houses, MORE (not fewer) home owners will stop paying on their mortgages and delinquencies will rise.  Already stretched homeowners will instead use their paychecks on other, more urgent needs.  After all, you’ve taken away the incentive for them to pay: they would have been kicked out of their dwellings otherwise.  This is simply moral hazard at work.  The resulting higher delinquency and more and more bad debt in turn will lead to reduced bank lending, and consequently fewer buyers.  The net effect? The housing price downturn will last longer, not shorter.

Wait, you say, have I not forgotten that lower foreclosures will reduce the supply of houses on the market and hence lead to more price stability?  Well, not exactly.  The problem of this “reduction in supply” is that it is not genuine.  Even though the banks cannot sell these houses, they are still missing the mortgage payments on them.  Such losses have not been eliminated, but rather extended over a longer period of time.  Worse, because of moral hazard, their losses will probably be bigger over time.  To make up for that, banks will have to (a) reduce lending elsewhere, (b) charge higher rates on other loans, or (c) receive more government subsidy, probably all of the three.  The costs of these losses on the existing mortgages will not simply disappear, but instead show up somewhere else as a reduction in other productive activities.  Even worse, a dollar of loss on a house that cannot be foreclosed, due to the leverage of the bank, will mean many more dollars of new loans that cannot be extended.  This is the multiplier effect in the money creation process.  Therefore, the reduction in demand will outpace the reduction in supply. 

There is more, what I have talked about above has not taken into account the very negative consequences of distorted economic incentives in the long run.  A symptom of the housing bubble is that too many people got into houses that they cannot afford.  With foreclosure moratorium, we are keeping them in the houses they had no business in buying in the first place.  That is in turn subsidized by government tax receipts and borrowings from overseas, all of which will eventually be paid for by everybody else including the future generations, in various forms of higher debt, higher taxes, and lower values for the US dollar.  The people who have missed out this free handout will learn their lessons and behave more riskily in the future.  After all, the gains are yours and the losses will be socialized - the government can be counted out to be there when their individual bets do not work out.   

B. “Tapping the 401(k) plan”: under Obama’s plan, consumers will be allowed to tap their 401(k) temporarily without the 10% withdrawal penalty.  This seems like a “free” way for home ownerships to get some cash in the pocket without government outlays.  This should help stabilize consumer spending and housing, right?

Well, again, not quite.  Remember, to get cash out of your retirement savings, the mutual funds that you own have to sell assets to meet redemptions.  The cash can not come from thin air.  A temporary measure like this will create an artificial shock of selling pressures in the equity markets.  The Dow and SP 500 are both down over 40% during the year, wiping out over $9 trillion of wealth.  The shock will certainly push it down more, wreaking havoc not only on those who sell, but also on those who elect not to sell.  That will undoubtedly NOT be good for consumer spending.  Furthermore, as the equity market is already at a stage of very low liquidity, small amounts of selling would lead to very significant drops in prices.  Simply put, there is a magnifying effect here again: when selling pushes a stock down $1, it’s not only the seller who got $1 less, but every other owner of the same shares now are $1 worse off.

In addition, I cannot but help wonder if this is not giving American consumers a rope to hang themselves with.  We all know that the savings rate in the US has been too low for too long.  Lifting the 10% penalty will certainly push it lower.  If the 10% penalty was preventing someone who would otherwise have liquidated from selling, that person would very likely sell now, definitely at significant losses, and possibly at the worst time.  In the current regime, if 401(k) owners needed short term cash, they could already borrow from their plans.  Allowing them to withdraw without penalty only serves as a way to permanently drain their retirement savings instead of borrowing short term against it.  Once years of savings are depleted, how long will it take to rebuild it back?  Not only that, wouldn’t it also be the case that when investments are made into 401(k)s again, they would possibly be at much different prices in the equity market, and hence preventing the owners from recuperating their losses on sales?  If we were to tinker with the savings and investment regimes, wouldn’t it be better to allow investors to offset all of their capital losses against their income this year?  This only accelerates the tax benefit to investors, and instead of depleting consumers’ tax advantaged retirement accounts, it gives them more incentives to use the non tax advantaged investments to cover short-term expenses.  If anything, the cost to the government could be lower, without the undesired consequences of sapping someone’s entire retirement savings.

All these lead to the main point of this blog, there are unintended consequences of government policies.  In setting these policies, the government has to take into account what often are very complex responses from the various constituents of the economy.  How individuals and companies modify their behaviors will affect the outcome of the policies, possibly more than the immediate effects of the policies themselves.  We have to stop treating the economy as a simple machine, like a car -  step on the gas and it will accelerate, put on the brakes and it will slow down.  In engineering, the study of feedback loops is an integral part of system design.  Why it is not part of mainstream economic thinking and policy setting is beyond my understanding.  It is time for that to change.

 

P.S.: Overall, my view on the housing market is that it would best be left alone.  Government efforts to prop up the economy are better spent elsewhere.  As the rest of the economy improves, the housing market will find its own “bottom”, which is far better than any government measures to keep it at an unsustainable, inflated level that was created in the last few years through the potent combination of low interest rates, lax lending standard, “affordability” mortgages, and government push for unnatural home ownership goals.  The negative effect of the housing price downturn will be compensated for by better use of society’s investment dollars away from housing over the longer term.  A fast race to the “bottom” might actually be positive for the economy.  So long as the housing prices continue to go down in dribs and drabs, consumers will continue to feel lousy about their wealth and constrain their spending, because they continue to feel poorer every week due to the “wealth” effect.  Bank lending will also continue to be constrained.  But once the “bottom” is reached, consumers and financials will accept their ultimate losses, and move on with their lives.  In particular, the “wealth” effect ceases to be that relevant any more.  Whether your house has dropped 30% or 40% does not make that much difference.  You will just live in the same house and pay out your mortgage over time.  What does make a difference is that your net worth is no longer shrinking, and you can look forward to the future now.  In that respect, a sharp but short downturn in housing prices is preferable to a longer and shallower one.