The Federal Reserve has backed itself into a corner and finding it hard to get out, according to James Galbraith, an economics professor at the University of Texas at Austin. He says while the U.S. economy is not heading into a catastrophe, he remains "downbeat" and claims there is data to support him.
By Greg Robb
Aug. 9, 2013, 9:15 a.m. EDT
WASHINGTON (MarketWatch) — The Federal Reserve has backed itself into a corner and is finding it hard to get out — and President Barack Obama won’t have much more luck trying to reform the big mortgage-buying giants.
That’s the view of James Galbraith, the son of renowned economist John Kenneth Galbraith and a progressive economist who teaches at the University of Texas at Austin.
He says while the U.S. economy is not heading to a catastrophe, he is “downbeat” — and says the data supports that.
Here’s an edited version of the conversation.
MarketWatch : Where is economy headed? The Fed and Wall Street economists seem upbeat about things. Are you?
Galbraith : I am habitually downbeat and I think the evidence tends to support that. We have seen a slowing growth of total output. It reflects two basic facts. One is that active fiscal policy has been tightening for some time, and is expected to continue to do so, and the other is that you’ve got a sharp reduction in the federal budget deficit simply because the tax take has been higher than expected. So those things would tend to put some slowing pressures on overall growth.
That said, I am not a catastrophist. I don’t think there is anything out there immediately which portends anything dramatic.
MarketWatch : So, more of the same?
Galbraith : More of the same, but on a slowing trend.
MarketWatch : Is Washington shooting the economy in the foot?
Galbraith : Washington has been shooting the economy in the foot for quite a long time, since 2010 at least. I think the main thing is that you’re getting a bite from higher tax revenues and that has just got to be cutting into private spending decisions at some point.
MarketWatch : Lot of talk about whether the Federal Reserve can taper — what’s your take?
Galbraith : I have been saying for a long time that the Fed is stuck, that it has backed itself into the zero-interest-rate posture and into the holdings that it has of mortgage-backed securities, and there is now a general expectation of low long-term interest rates going into the future. The process of trying to reverse that is going to cause a lot of turmoil and the Federal Reserve doesn’t like turmoil, so it is probably not going to do it.
In March, [Fed Chairman Ben] Bernanke was saying the Fed was going to gradually sell off its $1.25 trillion holdings of mortgage-backed securities, but now he’s saying “no, we’re going to hold onto those indefinitely.” And I think that reflects the situation that I was just describing.
Now they are talking about slowing down the rate at which they acquire new assets, that is what the word “tapering” apparently means. I was just reading an article that pointed out they can slow down the volume of purchases and still increase the share that they take out of a market, which is slowing and has been slowing the rate at which these things are produced.
The notion that the Federal Reserve can cavalierly change the course that it has been setting for years now I think is problematic and I think they are finding it problematic.
MarketWatch : What would be your advice to the Fed on how to go about it?
Galbraith : My advice would be, don’t do anything that is going to cause undo turmoil. If there is no compelling reason to do it, don’t do it. If it hurts, stop. It is the same advice I would give a small child.
MarketWatch : So keep buying assets?
Galbraith : They clearly are going to do that. The problem is that if they telegraph a change in policy, they get a sharply adverse reaction. And the reason for that is that very small absolute changes in the interest rates are large proportionately when the interest rate is very low.
MarketWatch : What do you mean that the Fed got backed into a corner?
Galbraith : Well, let’s say five years ago, the Fed moved its short-term interest rate to zero, and over time, there has been a consolidating view that, that is where it is going to stay. And that means that the long-term rates come down to reflect that general viewpoint. So as people become accustomed to expecting a zero federal funds rate, they will become accustomed to expecting a very low long-term rate on federal bonds and so the effort to reverse this is going to be a bit turbulent if not traumatic.
Either they can try to push up the long-rate while keeping the short-rate low and that is kind of reversing the quantitative easing in which case they get large proportionate changes. And you begin to have real pullback effects in the mortgage markets and things of that nature. Or, they [could] change the expectation of the short rate by raising them, but when they do that, they get an inverted yield curve.
So, one way or another, I think the best guess is that as much as they would like to talk about returning to some previously normal world, they are not in that world anymore. And even as they talk about it they get a reaction, but if they actually went ahead and did it in a determined way, they would get a very serious reaction. So the most likely scenario is that at that point they’d stop.
MarketWatch : The White House has launched a new campaign to engage Congress on ways to help the middle class, some popular ideas like helping students get a college education. What is your view on Obama’s economic agenda? Have they dropped the ball too?
Galbraith : Oh sure. I think there are some well-meaning things on this list. But if they wanted to help stabilize the middle class, [there are] two major measures that would have to be taken. First of all, would be a very substantial increase in the minimum wage, really putting their back into that. The president says he is for $9. I think $12 would be something that would have a significant effect on the structure of American labor markets and on the earnings of working people. You now have so much of the labor force out there in that relatively low-wage services sector. That is where you would want the effect of a labor market reform to be felt.
And the second thing would be on housing and foreclosures. And here, we just don’t see anything. The president has been talking up the line about dispatching Fannie Mae FNMA -3.23% and Freddie Mac FMCC -2.86% with a bullet to the head of each and, well, that would certainly liquidate the middle class.
If you want to create a world in which you are reliant on the market for privately originated mortgages and private securitization, with the reputation of the banks following the crisis, good luck, you are not going to get there. What would happen would be increasingly depressed housing market, a major asset that the middle class has had historically in this country. I very much doubt that is going to happen. It is a way of showing deference to an idealized free market concept, but it is also something that if it did happen, would pretty much negate a pro-middle-class agenda.
MarketWatch : Explain how a higher minimum wage would help?
Galbraith : The main effect is that the incomes of people who are working in the lower tier of the labor force would go up. Now some people say: “Well yes, but a lot of kids will lose their jobs.” That is not the experience of countries that have in fact introduced fairly high state minimum wages, Britain being the best example, but even if they did [lose their jobs], these are people whose, by and large, family situations would be better off because the adults in those families would be earning substantially more.
It would also have an effect on small businesses, raising their labor costs some but increasing their income because their customers would have more money to be spending.
The third thing is that is would it reduce the incentive to hire illegal labor.
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