Kevin Villani

The Boom/Bust Cycle Isn’t about Emotion

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My first experience with manias was in the 1950’s. As a pre-schooler, I was dragged along to the Filene’s Basement annual designer dress sale. Thousands of women of all types and sizes pressed against the glass doors opening into the subway station. Within minutes of the doors opening, these “maniacs” cleared all the racks and, holding armfuls of dresses, began stripping to their slips. That’s when I panicked.

Looking back, those women acted rationally. There was a limited supply of deeply discounted dresses available on a first come basis. They traded among themselves to get the right size and their most desired dress. Buyer’s remorse was cushioned by Filene’s liberal return policy.

The premise of U.S. financial regulation is that actors within private markets are irrational, but the evidence shows that it’s not maniacal, illogical behavior that sends markets into freefall.

Great Depression and Recession

Now in its seventh edition, Manias, Panics and Crashes: A History of Financial Crises, Charles Kindleberger’s seminal work provides the narrative that underlies virtually all public financial protection and regulation: First, the irrational exuberance of individuals transforms into “mob psychology” and fuels an asset bubble. Then, when the exuberance of a few turns to fear, the mob panics and overreacts, causing a crash that brings down both solvent and insolvent financial institutions.

In his memoir, the former Federal Reserve Bank President and Treasury Secretary Timothy Geithner, who was at the epicenter of the last crisis, concluded, “It began with a mania — the widespread belief that devastating financial crises were a thing of the past, that future recessions would be mild, that gravity-defying home prices would never crash to earth.”  

Most U.S. federal financial regulation originates from the Great Depression and the subsequent introduction of federal deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC), which was established in 1933 to protect “small” savers. All prior state attempts to provide insurance failed. Because there were no effective, non-politicized regulations that could prevent the moral hazard of insured banks and savings institutions taking on excessive risks, an extensive regulatory infrastructure was put in place.

Rational Actors

Now, the U.S. has about 100 financial regulators, including those in the U.S. Treasury and the Securities and Exchange Commission (SEC), the FDIC, and the Fed. With near-universal deposit insurance, bank runs have become a rarity, but systemic crises have occurred more frequently. It is incontestable that big bubbles eventually burst, asset prices crash, and financial crises ensue. What causes the bubbles to inflate to systemic proportions, and to ultimately burst, is more contentious.

At the time of Kindleberger’s analysis, individuals were assumed to be rational. The latest edition of his book, written after the 2008 financial crisis, postulates numerous theories about mob psychology (mania) that could lead rational individuals to produce irrational markets, but these ideas are all rather lame.

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There Is No Possible Reform for HUD

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“The Department of] Housing and Urban Development has done an enormous amount of harm. My god, if you think of the way in which they have destroyed parts of cities under the rubric of eliminating slums … there have been many more dwelling units torn down in the name of public housing than have been built.” ~ Milton Friedman, Interview, Hoover Institution, February 10, 1999

President-elect Trump’s appointment of Dr. Ben Carson as Secretary of Housing and Urban Development is being criticized on the grounds that he lacks the requisite administrative experience. More likely, Carson’s affront was to question why HUD exists.

Republican presidents have been ambivalent. Having bigger fish to fry, President Reagan appointed Sam Pierce HUD Secretary so that he could ignore it. George H.W. Bush repaid Jack Kemp’s political opposition by first making him HUD Secretary and then frustrating his attempts to eliminate the Department. HUD Secretary Alphonso Jackson, appointed by George W., was allegedly focused on participating in the traditional kickback schemes while his Assistant Secretary for Housing pursued homeownership policies that contributed mightily to the financial crisis of 2008.

Democratic presidents have used it as a platform to pursue other agendas. Jimmy Carter’s HUD Secretary Patricia Harris introduced Fannie Mae housing goals – quotas – as punishment for not appointing a woman to the Board of Directors. Between scandals, Clinton’s HUD Secretary Henry Cisneros promoted the homeownership goals that left both the financial system and the new mortgage borrowers bankrupt.

HUD’s budget is relatively small as compared to other federal departments, but it has always punched far above its budget weight in destructive power. To put HUD’s annual budget of about $50 billion in perspective, the cost of the homeowner mortgage interest tax deduction is two to three times greater, but HUD’s “mission regulation” of financial institutions has given it influence or control over trillions more.

The initial political interest in housing during the Great Depression was entirely Keynesian, i.e., related to the short-term potential to create jobs and relieve cyclical unemployment – the “infrastructure investments” of that era. The Democrat’s approach to construction, management, and allocation of public housing was generally implemented to benefit builders and rife with corruption. FHA and Fannie Mae were chartered mostly as off-balance sheet financial institutions to stimulate housing production on the cheap.

The problem of urban development, as many politicians and urban analysts saw it in the 1960s, stemmed from the 1956 Eisenhower initiative to build highways financed by the National Interstate and Defense Highways Act, a byproduct of which was that more affluent people commuted from the suburbs while leaving poorer families behind. The pursuit of the American Dream of homeownership left city administrations accustomed to cross-subsidizing municipal services in fiscal distress, creating a vicious cycle: as services declined, more affluent households moved out.

The Housing and Urban Development Act in 1965 established HUD as a separate cabinet department as part of LBJ’s Great Society to give a greater priority to housing and urban issues. HUD inherited a mishmash of various New Deal federal programs, ranging from public rental housing to urban renewal, as well as financial oversight of FHA and Fannie Mae.

Faced with steep “guns and butter” budget deficits, LBJ focused on ways to further encourage off-balance-sheet financing of housing construction through “public-private partnerships.” Republicans, led by Senator Edward Brooke of Massachusetts, convinced by academic studies that the urban riots of the 1960s were the direct result of poor quality housing and the urban environment and by lobbyists for housing producers, supported the Housing and Urban Development Act of 1968. The “goal of a decent home and a suitable living environment for every American family” was first introduced in the 1949 Housing Act. Title XVI of the 1968 Act “Housing Goals and Annual Housing Report” introduced central planning without specifying the goals, a timetable for implementation, or a budget.

In the late 1960s, the Weyerhaeuser Corporation produced a forecast of single-family housing production in the coming decade to assist with tree planting. Congressional math wizards divided the total forecast by 10 to produce HUD’s annual housing production goals for the nation. For the next decade, HUD Secretaries were annually paraded before their Senate oversight Committee on Banking, Housing, and Urban Affairs to explain why they did or did not meet these production goals.

Republicans have historically supported rental housing vouchers for existing private rental units for privately built housing to minimize market distortions. Republican HUD Secretary Carla Hills in the Ford Administration pushed HUD’s Section 8 subsidies for existing housing – something arguably better administered as a negative income tax – as a political alternative to the Democrats’ push for a return to public housing construction. But as a further political compromise, the largely autonomous local public housing authorities would administer these vouchers, leading to the same concentration of crime and urban decay as public housing. To borrow a phrase from former House Speaker Newt Gingrich, “Republican social engineering” isn’t necessarily better than “Democratic social engineering.”

The economic goals of “affordable” housing have generally been in direct conflict with urban development. When I proposed demolishing the worst public housing projects and redeveloping the land, using the proceeds to fund subsidies for existing private market housing (something partially achieved during the Reagan Administration), Clinton Administration officials scoffed at the idea.

HUD combines socialist goals and fascist methods that seriously distort and undermine markets. There is neither market nor political discipline on the enormous scope of its activities. HUD met unfunded goals through financial coercion, undermining both Fannie Mae and Freddie Mac, and their commercial banking competitors, with the collusion of the Senate Committee responsible for both financial and housing oversight, leading to the sub-prime lending debacle of 2008.

There is no economic rationale for a federal role in housing or urban affairs in a market economy. HUD represents a continuing systemic threat for which there is no cure. May it RIP.

Kevin Villani


Kevin Villani

Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.

This article was originally published on FEE.org. Read the original article.

Can Donald Trump Prevent the Economy from Falling Into a Black Hole?

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Interest rates will eventually rise without an even more devastating policy of financial repression. When they do, rising interest costs will produce a vicious cycle of ever more borrowing. We are already approaching the “event horizon” of spinning into this black hole of an inflationary spiral and economic collapse from which few countries historically have escaped. A substantially higher rate of growth is the only way to break free.

National economic growth is typically measured by the growth of GDP, and citizen well being by the growth of per-capita GDP. The long run trend of GDP growth reflects labor force participation, hours worked and productivity as well as the rate of national saving and the productivity of investments, all of which have been trending down.

The population grows at about 1% annually and actual GDP growth averaged 2% overall for 2010-2016 (using the new World Bank and IMF forecast of US GDP at 1.6% for 2016), hence per capita GDP grew at only 1%. Moreover the income from that 1% growth went primarily to the top one percent while 99% stagnated and minorities fell backwards.

Why we are approaching the Event Horizon
The Obama Administration annually predicted a more historically typical 2.6% per capita growth rate, consistent with the historical growth in non-farm labor productivity. How could their forecasts be so far off?

The Obama Administration pursued the most massive Keynesian fiscal and monetary stimulus ever undertaken. Such a policy generally at least gives the appearance of a rise in well being in the near term, as the government GDP statistic (repetitive, as the word “statistic derives from the Greek word for “state” ) reflects final expenditures, thereby imputing equal value to what governments “spend” as to the discretionary spending of private households and businesses in competitive markets. But labor productivity gains stagnated at only about 1%, most likely reflecting the cost and uncertainty of anti-business regulatory and legislative policies that dampened investment, something the Administration denied, trumping even a short term boost to GDP.

As a result the national debt approximately doubled from $10 trillion to $20 trillion, with contingent liabilities variously estimated from $100 to $200 trillion, putting the economy ever closer to the event horizon. Breaking free will require reversing the highly negative trends by reversing the policies that caused them.

Technology alone isn’t sufficient
Obama Administration apologists argued that stagnation is “the new normal” citing leading productivity experts such as Robert Gordon who dismissed the potential of new technologies. Many disagree, but Gordon’s findings imply even greater reliance on conventional reform.

Fiscal policy won’t be sufficient
Raising taxes may reduce short term deficits but slows growth. Cutting wasteful spending works better but is more difficult.

The list of needed public infrastructure investments has grown since the last one trillion dollar “stimulus” of politically allocated and mostly wasteful pork that contributed to the stagnation of the last eight years. Debt financed public infrastructure investment contributes to growth only if highly productive investments are chosen over political white elephants like California’s bullet train, always problematic.

Major cuts in defense spending are wishful thinking as most geopolitical experts view the world today as a riskier place than at any prior time of the past century, with many parallels to the inter-war period 1919-1939.

The major entitlement programs Social Security and Medicare for the elderly need reform. But for those in or near retirement the potential for savings is slight. Is Medicare really going to be withheld by death squads? Are benefits for those dependent on social security going to be cut significantly, forcing the elderly back into the labor force? Cutting Medicare or SS benefits for those with significant wealth – the equivalent of a wealth tax – won’t affect their consumption, hence offsetting the fall in government deficits with an equal and offsetting liquidation of private wealth. Prospective changes for those 55 years of age or younger should stimulate savings and defer retirement, improving finances only in the long run.

The remaining bureaucracies are in need of major pruning and in numerous cases elimination but they evaded even budget scold David Stockman’s ax during the Reagan Administration.

Americans will have to work more and consume less
That is the typical progressive economic legacy of excessive borrowing from the future.

The first Clinton Administration created the crony capitalist coalition of the political elite and the politically favored, e.g., public sector employees and retirees, subsidy recipients and low income home loan borrowers. The recent Clinton campaign promised to broaden this coalition, which would have accelerated the trip over the event horizon.

Reform that taxes consumption in favor of savings and a return to historical real interest rates could reverse the dramatic decline of the savings rate. Regulations redirecting savings to politically popular housing or environmental causes need to be curtailed in favor of market allocation to productive business investment.

Repeal and replace of Obama Care could reverse the trend to part time employment. Unwinding the approximate doubling of SS Disability payments and temporary unemployment benefits could reverse the decline in labor force participation.

Service sector labor productivity has been falling since 1987, the more politically favored the faster the decline. Legal services are at the bottom, partly reflecting political power of rent-seeking trial lawyers, followed by unionized health and then educational services. Union favoritism through, e.g., Davis Bacon wage requirements and “card check” increases rent seeking, particularly rampant in the unionized public sector.

Competition, of which free but reciprocal trade has historically been a major component, has traditionally provided the largest boost to well being by realizing the benefits of foreign productivity in a lower cost of goods while channeling American labor into employment where their relative productivity is highest. The transition is often painful, but paying people not to work long term is counterproductive. Immigration of both highly skilled and low cost labor (but not dependent family) generally contributes to per capita labor productivity in the same way as free trade.

None of this will be easy. The alternative is Greece without the Mediterranean climate or a sufficiently rich benefactor.

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Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.

A Really Big Short Still Awaits

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When testifying in 2010 before the Financial Crisis Inquiry Commission into the financial crash, then Federal Reserve Board Chairman Ben Bernanke recommended only one reference, Lords of Finance: The Bankers Who Broke the World (2009), presumably for the narrative that insufficient money printing in the aftermath of the Great War lead to the next one. Right idea, wrong narrative!

The US homeownership rate peaked at a rate well above the current level almost a half century ago mostly funded by a system of private mutual savings banks and savings and loans. The historical justification for federal “secondary market” agencies was political expediency – exemption from now obsolete federal, state and local laws and regulations inhibiting a national banking and mortgage market. Now government-run enterprises account for about 90% of all mortgages, with the Fed their primary funding mechanism, what the Economist recently labeled a de facto nationalization.

The Historical Evolution

How did the private US housing finance system repeatedly go bankrupt? To quote Hemingway: Gradually, then suddenly. The two competing political narratives of the cause of financial market crises remain at the extremes – either a private market or public political failure – with diametrically opposite policy prescriptions. The politician-exonerating market failure narrative has not surprisingly dominated policy, with past compromises contributing to the systemic financial system failure, the global recession of 2008 and subsequent nationalization.

The Great Depression stressed the S&L system, but the industry’s vigorous opposition to both federal deposit insurance and the Fannie Mae secondary market proved prescient as the federally chartered savings and loan industry eventually succumbed by 1980 to the federal deposit insurer’s perverse politically imposed mandate of funding fixed rate mortgages with short term deposits and competition from the government sponsored enterprises.

The S&Ls were largely replaced by the commercial banks. To make banks competitive with Fannie and Freddie, politicians and regulators allowed virtually the same extreme leverage, in return for a comparable low-income lending mandate – CRA requirements leading to a market dominating $4 trillion in commitments to community groups to whom the Clinton Administration had granted virtual veto power over new branch and merger authority.

The Financial Crisis of 2008 and the aftermath

The Big Short by Michael Lewis and more recent movie portrayed not just banker greed but the extreme frustration of those shorting the US mortgage market stymied by a housing price bubble many times greater than any in recorded US history that refused to burst. The reasons: 1. the Fed kept rates low and money plentiful, and 2. whereas banks would have run out of funding capacity, the ability of Fannie and Freddie to continuously borrow at the Treasury’s cost of funds regardless of risk and their HUD Mission Regulator requirement to maintain a 50% market share kept the bubble inflating to systemic proportions.

The Obama Administration fully embraced the alternative private market failure narrative in Fed policy, regulation and legislation:

  • To partially ameliorate the effects on the real economy of disruption to the global payments mechanism the Fed had to bail out the banking system. QE1/2/3/4 and ZIRP (zero rates), now NIRP, did this by re-inflating the house diazepamhome price bubble, postponing defaults while allowing banks risk-free profits. The Fed – and taxpayers – would lose more than the entire S&L industry did should rates rise by a comparable amount if it marked its balance sheet to market.
  • Regulators had to appear to punish the banks. In response to paying hundreds of billions of dollars in what the Economist labeled “extortion” – some of which ironically went to populist political action groups – and the subsequent oppressive regulatory regime, U.S. commercial banks are exiting the US mortgage market in spite of ongoing profits enabled by extreme leverage.
  • One legislative centerpiece, the Dodd Frank Act passed in July 2010 in direct response to the financial crisis, doubled down on political control of financial markets without addressing the future of Fannie and Freddie. The other, Obamacare, enacted four months earlier, was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available.

The Long Term Consequences

Bernanke’s focus on choosing the narrative was useful, but the political choice of the market failure narrative appears to reflect convenience rather than conviction. The direct taxpayer costs of implicit or explicit public insurance and guarantees come with both a whimper – tax savings amounting to tens of billions annually due to the deductibility of interest costs – and a bang – future taxpayer bailouts generally delivered off-budget.

Fannie and Freddie conservatorship deftly avoided debt consolidation while dividends reduced reported federal deficits. The student loan market has also been de facto nationalized, with potential unbudgeted losses totaling hundreds of billions. Obamacare was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available, but under-budgeted health insurance subsidies predictable caused massive losses and health insurers are now withdrawing from the market.

Monetary policies caused household savings to stagnate as returns to retirement savings evaporated. Defined obligation public pension funds were all rendered technically insolvent when funding is valued at current market returns rather than the assumed rate as much as ten times that. The failure of the economy to grow per capita was explained as the “new normal”. But politicians made no attempt to reflect the implied technically insolvency of public pensions or Social Security and Medicare.

Private firms fail, but private markets rarely do. Public protection and regulation makes firms “too big to fail” until markets fail systemically. The current and projected future public debt bubble is unsustainable, and financial markets will eventually ignore the accounting deceptions and pop it. The relative weakness of other sovereign debt is delaying the inevitably, making The Really Big Short a good title for a Michael Lewis’s sequel. Politicians and central bankers will again say “nobody saw this coming”. What then?

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Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath. This article was originally published at FFE.org

Who’s More Fascist: Presidential Candidate Donald Trump or Former Federal Reserve Chairman Ben Bernanke?

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How Economists Facilitated the Transition of Erstwhile “Market” Economies to Fascism

The Left calls Donald Trump a fascist invoking the memory of Hitler and Mussolini, to which Trump might reply: “they were losers; I’m no loser.” Fascism is in essence the political control of the private economy, historically justified by democratically elected leaders to defend against perceived or orchestrated external threats. Progressive war politicians from Presidents Wilson and FDR to Johnson and Obama and now candidate Clinton have pursued this same goal in the US as has the social democratic European Union.

At the recent meeting of the G20 leaders and central bankers political responsibility for and control over their respective economies was assumed, but their Alfred E. Newman “what, me worry” smiling faces belie the fragility of the current global economy. The political distortions to both the financial and real economy have arguably never been greater, to which politicians and their economist enablers prescribe more of the same mostly wasteful public spending financed by money printing, a cure reminiscent of medieval bloodletting.

Having never been of much use to business, economists mostly followed “Say’s Law” that supply creates its own demand (for academic economists). They got their first pervasive shot at political power when President Wilson – an academic who chafed at constitutional constraints – created the Federal Reserve which helped US bankers fund the Allies until he could mobilize a war economy, making the first WW “Great.” The unprecedented death and destruction of the Great War knocked the global economy off kilter and the massive international war debts made stabilization politically difficult. As the creditor and least damaged victor, the US economy boomed in the roaring ’20s, followed by a bust.

Purveyors of the “dismal science” had previously counseled that politicians had to own up to the cost of war until the private economy recovered. While the “arts” of manipulating the value of currency and public spending financed by coercive taxes and often uncollectable debt as well as coercive regulation were as old as politics and war itself, post WW I economists became noticeably less “dismal” and purportedly more “scientific,” believing that such “macroeconomic” interventions could be calibrated to “tame business cycles” in part by transferring or defaulting on war debts. This was complemented by “microeconomic science,” the recent objective of which has been to prove that individuals aren’t always perfectly rational (and by inference in need of paternalistic political protection and direction). Macroeconomists contend that this psychological defect is contagious, conjuring irrational mobs running on banks (or attending Trump rallies).

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