A paper written by four economists released this past Friday,”Housing, Monetary Policy, and the Economy,” has been garnering a fair amount of attention. The entire thing is interesting and makes a strong case that “more than half the underperformance in this recovery” can be attributed to brutal decline in housing and related sectors. One part of the paper deals with monetary policy and how the crash in home values and the tightening of credit standards have impaired the Federal Reserve’s ability to stimulate the economy through lowering interest rates.

Usually, mortgage rates are one of the main channels for the Fed’s interest-rate policy to have an effect on the real economy. Basically, when the Fed lowers rates, mortgage rates come down in turn, and homeowners can refinance at the new lower rates, reducing their mortgage payments and freeing up that money to do other things like spend or invest. And while the Fed has been successful in lowering mortgage rates, there are still millions of homeowners paying above-market mortgage rates because they are underwater and can’t refinance. The authors of the paper describe the problem this way:

We have presented circumstantial evidence consistent with diminished transmission: banks report tighter lending standards; builders report increased difficulty of borrowing; since many homeowners are significantly underwater, they cannot refinance into lower rates. Clearly households will display diminished sensitivity to changes in market interest rates if they simply cannot obtain loans at those rates. Further, in our analysis of cross-state data we presented strong evidence that states with particularly moribund housing markets have performed particularly poorly. Households in these states have not been able to refinance into lower interest rates. This, too, is consistent with the notion that in such states monetary policy has had diminished effect.

This is clearly a huge problem for effective macroeconomic stabilization . And it’s something that’s gotten the attention of Congress, the Fed, and the White House. The Home Affordable Refinance Program, which allows underwater homeowners with mortgages guaranteed by Fannie Mae and Freddie Mac to refinance, has had nearly 1,000,000 successful refinancings, and with reforms to the program, that number should go up a bit faster. New York Fed chair William Dudley has also supported more aggressive action to expand refinancing, as have Democrats in Congress. President Obama put forward a plan to allow underwater homeowners without Fannie and Freddie mortgages to refinance.

The problem is that despite the White House, Congressional Democrats, and the Fed all wanting to get more involved in refinancing and fixing the transmission channel for monetary policy, the best they have been able to do is convince the Federal Housing Finance Administration, which oversees Fannie and Freddie, to agree to reforms of the original HARP program. Congressional Republicans, of course, have been very skeptical of any government-sponsored refinancing efforts supported by Democrats. The FHFA is largely seen as an obstacle to mass refinancing for underwater homeowners. Their primary concern, it seems, is to minimize taxpayer exposure to Fannie and Freddie.

What the housing policy problem reflects more broadly is how difficult the politics of recovery and stabilization have been. Before the Great Recession, it was assumed that the Fed would be able to stabilize the economy through interest rate policy, and if things got really bad, “unconventional” policy measures. But then a housing market collapse touched off a financial crisis and a historically deep recession. But unlike other asset-bubbles whose popping brought about economic hardship, the housing crash (unlike, say, the stock market decline following the tech bubble) actually affected the very means the Fed uses to prevent brutal, sustained downturns in the first place.

And now since the political branches have to get involved in order to fix things, any effort to assist the housing market gets caught up in intensely partisan size-of-government debate which have more-or-less doomed government efforts that would require taxpayer dollars.

These circumstances, it seems, should call into question the institutional set-up we have to deal with monetary policy and responding to economic downturns. They can also illuminate why the recovery has been so slow and uncertain.

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