Federal Reserve and Monetary Policy: A Sticky Situation

Greenspan's conundrum still has no explaination. I think it is related to the housing market. One needs a change of perspective to understand this. The current thinking is that housing value is related to labor's income. In other words, the Neoclassic Theory of Production's output function can be written as Y = f(L, K, I) where Y is the output function, L is the labor number, K is capital and I is investment.

Labor produces wealth by depositing their wages into the bank which in turn generates more wealth. We know that people are taking equity out of their homes by various means. The equity to liquidly processes must be the mechanism by which Greenspan's conundrum is based. The equity to liquidly process is independent of the labor force (my opinion, no proof), yet it adds to output. The equity to liquidly process is also independent of a home's price (the value of the credit received is dependent , but not the actual process of equity to liquidly). Therefore, the production function can be written as Y = f(L, K, I, E-L) where E-L is the production factor due to the Equity to Liquidly process. In other words, the E – L factor term has its own supply and demand curves and the equilibrium is set by the intersection of these two curves. The E – L factor is independent of labor, capital and investment which are the conditions for usage in the Neoclassical Theory of Production.

The Equity to Liquidly factor has the time span of home equity line of credit time span or short time span reqire to recoup a housing investment (flipping etc...). This is the new constraint on how interest rates are distributed (the shape of the yield curve). One can use a production function of the following: Y = f(L, E-L). This production function has an L, E-L isoquant. The L, E-L has an elastic substitution function.

The biggest problem with this process is that the lenders use various neutral risk strategies to protect themselves. As interest rates rise, so does the cost of these neutral risk strategies. This is were the problem is in the housing market. It is not that the price of homes have gone up, it is the fact that Equity to Liquidly process is at risk of failing due to failing hedge funds or a reduction of risk exposure.

There is a connection between GDP and the Equity to Liquidly process. If the E – L process produces less output, this in turn will decrease GDP. A lower GDP will reduce demand for housing which will decrease the demand for E – L. So on and so on... If the Federal Reserve steps on the US economic brakes too hard, they will cause a melt down in the hosing market due to a lack of funding for the neutral risk strategies which in turn will cause Fannie Mae and Freddie Mac to go to the US Treasury to bail them out.

Greenspan has, yet again, repeated his opinion that there is no risk in the GSE which makes them ripe for a hard fall. If Fannie and Freddie are forced to reduce their ability to function in the secondary market and if the other financial companies also reduce their exposure to the housing market, then it is “good night” for the US economy and hello “soup line”.