In 1984 Larry Summers and Greg Mankiw, two of the top 20 rated economists according to the RePEc Author Service, wrote a well-touted paper entitled “Do Long-Term Interest Rates Overreact to Short-Term Interest Rates?”
The reason that I dug up this wonderful piece of academic literature is because it relates to the following two claims of mine: (1) even our most touted economists do not have a clue; and (2) for more than 25 years the Federal Reserve sat back and allowed the Government Sponsored Enterprises, Fannie Mae and Freddie Mac, to control the setting of long-term rates in the United States and thus conceded control of a large and significant portion of our economy to the detriment of our society.
Essentially what Summers and Mankiw did in the above study that I mentioned was to test the hypothesis as to whether financial markets are myopic and whether changes in long-term rates overreact to changes in short-term rates. Based upon the standard set of esoteric equations that only economists seem to appreciate, Summers and Mankiw came to the following conclusion:
“While ‘rejecting decisively’ the traditional expectation hypothesis regarding the term structure, our statistical results also lead us to conclude that long term interest rates ‘do not’ overreact to either the level or the change in short term rates. This finding suggests that participants in bond markets are not myopic or overly sensitive to recent events. Our statistical results also suggest that most variations in the yield curve reflect changes in liquidity premia rather than expected changes in interest rates.”
Now remember this. Summers and Mankiw wrote their enlightened paper in 1984, just shortly after a 4-year period starting in January 1978 through 1981 in which: (1) long term mortgage rates in the United States rose 950 basis points from 9.0 per cent to a high of 18.5 per cent; (2) the CPI rose nearly 790 basis points from 6.8 per cent to a high of 14.7 per cent; and (3) 1-year treasury rates rose 1,060 basis points from 7.3 per cent to a high of 17.9 per cent.
Hmmm. And Mankiw and Summers concluded that long term rates “do not” overreact to either the level or change in short term rates? The only thing that I have to say to that is this. “Wow! And double Wow!”
It makes me wonder if Mankiw and Summers knew anything about Fannie Mae, Freddie Mac, business, and oligopoly theory when they did their study. I can come to no other conclusion than this: they did not.
Unlike Mankiw and Summers, it is my claim that as a result of the unquestionable “OVERREACTION” of long-term rate changes to short-term rate changes in the late 70s and early 80s, followed by the Fed’s unconscionably conceding long-term rate control to Fannie Mae and Freddie Mac, that we our living through our current Debt crisis.
It is my claim that Fannie Mae and Freddie Mac took advantage of the overreaction in long-term rates nearly 30 years ago, misused their rate-setting powers to line the pockets of their executives, while our economists sat around in wonderment believing in broken theories.
To begin my argument, let me point out that over the 27-year period since Summer’s and Mankiw’s paper (almost the full time for a 30-year mortgage-rate loan to mature), inflation as measured by the CPI in the United States has averaged 2.99 per cent; yet only very recently have long-term rates begun to come into sync with long-term inflationary expectations.
As another data point, let me point out that within a 15-year period (1992-2007) American homeowners increased the total amount of long-term debt on our housing from $2.8 trillion to $10.2 trillion. In fact, we added more “long-term” housing debt than we did the better known national debt, which only rose from $4.1 to $9.0 trillion, during the same time period.
The combined Supply of new U.S. Debt (mortgage and national debt) over that 15-year period stimulated our economy at nearly a rate of $1.0 trillion a year. Talk about Keynesian economics! No wonder Alan Greenspan seemed like a genius throughout his reign.
How did this happen, considering the Fed’s continuous oversight of our economy and Summer’s and Mankiw’s theoretical assumptions? There was one reason and one reason alone. The financial markets were not operating efficiently and the economists that we relied upon to oversee our economy did not understand the oligopoly power of the GSEs—and how the GSEs made money.
In truth, what happened in regard to long-term rate history can be explained easily through Supply and Demand. And here is how. Fannie Mae and Freddie Mac controlled Supply by setting prices (long-term rates) to their advantage. And by “slowly” decreasing long-term mortgage rates over a 25-year period, Fannie Mae and Freddie Mac benefited in two different ways: (1) through one refinancing period after another; and (2) through trading on inside information.
Firstly, as a result of “cash outs” and simple amortization theory, refinancing increased housing prices, thus raising debt, which in turn raised revenue and income to Fannie Mae and Freddie Mac. Secondly, having control and knowing the direction in which rates were going to move, Fannie Mae and Freddie Mac executives used inside information to selectively choose which of the securities that they would purchase, keeping those that would likely pay down the slowest, also providing another way for windfall profits.
Since long-term rates were set at an “extraordinarily” high level in the early 1980s, then followed by an extended period of expected long-term inflation in the 3 per cent range, Demand has always been there for long-term debt offerings whether at 12 per cent, 10 per cent, 8 per cent, 6 per cent (most of which was being offered through mortgage-backed securities and not U.S. treasuries). Mortgage-backed securities offered quite a hedge against inflation. In fact, with the comparatively high bond rates of MBSs to those of short-term bonds, the more Supply of MBSs the better.
Hindsight you say? Considering technological productivity gains, the fall of the Berlin Wall, China-India-Brazil’s development, and globalization in general, how long should it have taken our esteemed economists to understand that inflationary trends could be somewhat tame over the long haul? How long should it have taken our esteemed economists to understand that Demand was not the driving force behind long-term rates and our debt, but that Fannie Mae and Freddie Mac were driving rates through their own self-serving pricing strategy?
Baloney you say? I say Baloney right back to you. As someone who was responsible for monitoring the risk of a large $600 billion portfolio of mortgage-backed securities throughout the entire 1990s, I saw Fannie and Freddie’s growth and knew what they were doing with long-term rates. And since 2001, when I first supported the effort of the primary mortgage insurance (PMI) companies to get Congress to reign in the power of the GSEs, I have continued to try to enlighten our financial leaders, both in Congress and the Fed about long-term rate setting—yet no one would listen then, nor do they listen to this day.
So now in this period of QE2 where rate setting is the key question of the day, I say hang on to every word that comes out of the mouths of our esteemed economists if you want. I am sorry, but I have no choice but not to. They have no idea.
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