Housing and the Economic Expansion

The Great Recession is over. Remember, the recession ended in June 2009 getting close to two years ago.

To many, it sure doesn’t feel like it. Since the second quarter of 2009, over the last six quarters, real GDP has grown by 4.5%. The average year-over-year growth rate for the five quarters since the recession ended is 2.3%. This is way below historical experience.

The reason: housing usually leads the economy into a recession, and, housing usually leads the economy out of the recession.

Not so this time.

And, this is why we are in the mess we are in. Housing is not going to rebound any time soon.

For one thing, banks and thrift institutions (what are they?) really don’t want to provide financing for mortgages. They really don’t want to hold mortgages. For another, the mess with Fannie Mae and Freddie Mac is so uncertain and confused and uncomfortable that they want to have as little to do with mortgages as possible.

In order to understand this I had to go through the mortgage process myself last year. I have no problem getting a loan. I went to the bank where I do most of my business and asked about getting a loan. Sure, they said, and arranged a meeting with the mortgage banker they do business with who approved my loan and all of a sudden my mortgage is with Fannie Mae and I am making payments to the mortgage servicing subsidiary of a major bank somewhere far to the west of Philadelphia. Never in my life have I had a mortgage in the hands of Fannie Mae. Oh, well…

This is, to me, the paradigm of the banking industry. Banks, especially smaller banks, don’t want to hold mortgages on their balance sheets. And, this is just what we wanted it. In the late 1960s and early 1970s when I was in Washington, D. C. and we were creating the mortgage-backed security the idea was to get mortgages out of the commercial banks and thrift institutions and into the hands pension funds and insurance companies who needed long-term assets. Then the depository institutions could lend more.

Why did we create the mortgage-backed security? So, politicians could get re-elected. If more families in America could own their own home through things the government did, then they would be more likely to vote back into office the people that were responsible for their owning their own home.

Likewise with lower income housing, after all, the number one job of politicians is to get re-elected.

So, the United States government got into the business of inflating the housing sector so that
more-and-more American families could own their own home.

How successful was this? Well, in the early 1970s, no mortgages were traded on any capital market in the world. Michael Lewis’ incredible book, “Liar’s Poker”, related to the middle- to late-1980s, and was a large part about the market for mortgage-backed securities which had become the largest component of the capital markets. And, as they say, the rest is history.

But, housing was always the fulcrum on which economic cycles turned. The basic reason was that housing construction could easily be started up and stopped and started up again. The longest post-World War II recessions (before the Great Recession) were one year and 4 months in length and there were only two of them. In order to slow down economic growth and fight inflation, the Federal Reserve would raise interest rates and this would cause mortgage lending to slow down or stop for a time. After sufficient time the Federal Reserve would lower rates once again, mortgage lending would pick up and economic growth would expand once more.

Business lending always lagged the movements in mortgage lending.

It seems as if mortgage lending and housing construction has tapped out. The credit inflation of the housing industry of the last sixty years cause sufficient dislocations that it is going to take a while for the United States economy to re-structure so that the housing industry can pick up once again.

Financial institutions are still facing major, major problems related to the housing industry, not counting the major problems relating to commercial real estate. Commercial banks are slowly accepting the fact that they are going to have to buy back many troubled mortgages, especially mortgages that were sold to Fannie Mae and Freddie Mac. Bank of America has paid back a little, but more is expected. JPMorgan Chase also has a large exposure. What is the hole? Standard & Poor’s has estimated that banks will have to buy back around $60 billion in bad mortgage loans which they sold to others. Some estimates place this total as high as $150 billion. (http://dealbook.nytimes.com/2011/02/09/banks-could-face-60-billion-tab-on-bad-loans/?ref=todayspaper)

In addition to this, the latest statistics indicate that more than one in four mortgages outstanding are underwater, that is, these mortgages are on homes that have a market value less than the amount owed on the mortgage. Homeowners facing this situation are still walking away from their obligations. Who picks up the difference? And, housing prices still remain weak in many markets within the nation.

About one in four individuals in America are either unemployed or under-employed. Savings can only go so far in keeping up payments on the home mortgage. And, 30 states have run out of money in their unemployment trust funds and are borrowing from the United State government to cover the shortfall. How long is this going to continue to be covered?

Manufacturing businesses are only running at three-fourths of capacity, up slightly from historical lows. With so much idle capacity, businesses are not interested in purchasing more capital and hiring more workers to create jobs and incomes. Purchasing seems to be very skewed…basics and luxuries…and computers. This is not very encouraging for a near term pickup.

With little or no housing pickup, expectations for a strong business pickup are pretty low. And, the Fed’s QE2 is not going to have a major impact on the reduction in unemployment or under-employment!

People have one way out of this dilemma in the short run. Inflation!

Inflation may not put the people back into a job, but it can cause housing prices to rise and this can buy them out of the underwater situation. Still, commercial banks, I believe, want to have as little to do with holding mortgages as possible. And, if they originate, or get their mortgage banking friends to originate mortgages, who are they going to sell them to?

Even so, all this will just postpone the housing problem until another time, just like we have done for the last sixty years. We just see high levels of under-employment, low levels of capacity utilization, high amounts of inflation, more debt and more debt, and where does this end?

The Great Recession is over. However, the Great Recovery is nowhere in sight.

Interpreting the Recent Behavior of the Monetary Aggregates

All research seems to indicate that, over time and everywhere, inflation is a monetary phenomenon. If this is true then we need to take some account of monetary aggregates in the short run so as to better understand what is taking place and what the current situation implies for the future. Also, it seems as if interest in the monetary aggregates might be surfacing once again. (See my post, http://seekingalpha.com/article/217598-monetary-targets-a-fresh-take.)

Let’s look at the current situation beginning with the quarter that followed the start of the Great Recession, the first quarter of 2008. If one looks at the year-over-year growth rate of the M2 measure of the money stock, things look relatively benign. Growth remained modestly above 6% through the first nine months of

the recession, but rose to over 10% by early 2009. However, this did not signal that monetary policy was working even though the end of the recession has been dated as July 2009. In fact, in looking at all the other monetary measures one could discern some troubling behavior that might indicate a deeper recession and a very slow recovery.

For example, the behavior of this measure certainly did not track the performance of bank reserves or the monetary base. Through the first nine months of 2008, total reserves in the banking system averaged a little under 5%, year-over-year. In the second quarter of 2009, the rate of increase was over 1,800%! The monetary base performed in a similar fashion. For the first nine months of 2008, the monetary base grew around 2.5% year-over-year. This increased to more than 100% in the beginning of 2009.

Of course, we know the reason why these reserve aggregates grew so rapidly while the money stock measure picked up only modestly. Excess reserves in the banking system went from less than $2 billion in the second quarter of 2008 to over $800 billion in the first quarter of 2009. The Federal Reserve was supplying funds to the banking system. However, the banking system was just holding onto them!

There was another movement within the monetary aggregates that was also of interest during this time period. The growth of required reserves, the reserves the banks had to hold behind their deposits, rose throughout 2008 but not nearly at the pace of total reserves or the monetary base. Note, however, that the growth rate of the non-M1 component of M2 remained relatively constant throughout 2008 and 2009 which indicated that a lot must be happening within the M1 measure of the money stock.

Here we see that through the first six months of 2008, the M1 money stock hardly grew at all. However, starting in September 2008 which marked the beginning of the financial crisis, this measure took off and was growing by almost 17% in early 2009. Growth was mainly in the demand deposit component of M1.

Two things were happening here. First, interest rates fell dramatically in 2009; keeping money in interest bearing accounts at banks and thrift institutions did not make much sense. Second, as people lost jobs and the economic environment became more and more uncertain, people and businesses moved assets from less liquid vehicles to transaction balances (demand deposits and other checkable deposits) so as to be able to buy necessities and to pay bills.

It is very important to identify this behavior because it explains a lot about how people were using their wealth at this time and what kinds of pressures they were feeling. This information helps us understand why the economy is performing the way it is and what implications this kind of behavior has for the future.

Taking this analysis into 2010 we see that the growth rate of M2 drops off drastically to less than 2%, yet M1 continued to incease at rates in excess of 5%. This is because people continued to transfer funds from interest-bearing accounts into transaction accounts. This is supported by the information on the growth rate in required reserves which was still above 10%. Note, that because of this the Federal Reserve has needed to continue to supply more reserves into the banking system to handle this increase in required reserves yet maintain the extraordinarly high levels of excess reserves in the banking system, reaching more than $1.0 trillion in the fourth quarter of 2009.

What this indicates to me is that the behavior of people and of the business community has not changed much over the past two and one-half years. People are still scared. Because of the tepid economy, high unemployment, and the uncertainty about the future, economic units still prefer to put their funds into transaction accounts so that they can facilitate their needed expenditures. This kind of information does not give one much confidence.

Furthermore, this kind of behavior is not what is seen before economic recoveries pick up steam. And, with the M2 measure of the money stock growing below 2%, year-over-year, one can only conclude that money is not entering the economy in a way that will stimulate future business expansion. Only when bank loans begin to increase and, consequently, M2 begins to expand more rapidly, then, maybe, confidence in the recovery will grow.

To me, monetary information is very valuable in trying to understand what is happening in the economy and where the economy might be going. However, the analysis of monetary aggregates must not be the kind of “cookie-cutter” analysis done in the 1970s and 1980s. Good analysis of the monetary aggregates is very complex and must include some historical analysis with it.

The Problems of Recovery

Comparisons abound between the Great Depression of the 1930s and the Great Recession of the 2000s. So far, we seem to have avoided the depths that were reached in the earlier experience, but we still have to consider whether or not the breadth of the two might be similar. That is, almost everyone one forecasting the recovery of the United States economy in the 2010s seems to be expecting that it will be a long, slow process.

The comparison I would like to consider in this post is the possibility that both of these periods represent a time in which the United States economy was going through a substantial structural change. Many people that have studied the 1930s period argue that the economy that existed in the United States in the 1950s was substantially different from the one that existed in the 1920s. Huge shifts took place in both manufacturing and agriculture throughout the 1930s and these shifts were just accelerated in the 1940s, a period of world war. The underlying cause of this change: technology had changed and the American economy had to adjust to become a modern nation. However, the mismanagement of the financial crisis in the 1930s just exacerbated the depth of the decline.

The argument can be made that major structural changes had to take place in the United States economy as it entered the 21st century. Changes of the magnitude of the present adjustment did not take place during the shorter, less severe recessions of the post-World War II period because the buildup of technological change takes time in order to build up a sufficient backlog of the new technology to really be disruptive. By the end of the 1990s, the structural change connected with the move from a society based upon manufacturing to an information society was ready to occur.

This buildup was not really a sudden one. It has been occurring throughout the last fifty years or so. I believe that the decline in the figures on capacity utilization for the United States captures this change very well.

Note in the accompanying chart that capacity utilization continues to decline throughout the whole period since the late 1960s. Obviously, cycles in this measure took place that were related to the various recessions occurring during the time span, but each new peak in capacity utilization never exceeds the peak it had reached in the previous cycle.

This, I believe, captures the changing nature of the United States economy and the movement from the foundational base of the Manufacturing Age to the growing impact of information technology and the Information Age. The conclusion that can be drawn from this is that the United States economy is not going back to where it was. But, this will take time.

Let me just point out three important factors that are playing a huge role in this change: evolving technologies, changing structure of the labor market, and the rise of the emerging nations.

First, the core of American commerce is not going to be manufacturing as we have known it. The future belongs to information technology, biotechnology, and knowledge. For the government to attempt to “force” workers back into jobs they held in the manufacturing world is just going to postpone the changes that WILL take place and threatens the stability of the society by re-establishing the inflationary environment of the last fifty years.

Second, the age of the labor union is past: non-public sector labor unions are legacy. There was a time when labor unions were needed to temper the pressures and demands of the industrial age of the large corporation who needed large numbers of physical laborers. These unions now compose less than half the union population in America yet have an over-sized impact on the politics of the country. In the next fifty years, the importance of the labor union is going to decline, economically and politically, as the United States moves from the manufacturing base that has dominated the last fifty years into the Information Age described in the previous paragraph.

Third, the United States, although it will remain the number one economic and military power in the world, is going to see its relative position in the world decline. The reason is that major emerging nations are beginning to feel their power and exert it. The immediate group of nations that come to mind are the BRICs. But, there are others. China, as we well know, is starting to exert its influence throughout the world. We see Brazil directly challenge America in the World Trade Organization concerning tariffs and subsidies. (See “Tax Move by Brazil Risks US Trade War”: http://www.ft.com/cms/s/0/dbf4284c-2afa-11df-886b-00144feabdc0.html.) And, more of this is to come! This is going to provide its own pressure for the economic structure of the United States to change.

These adjustments are going to take time. There will be substantial pain for those of working age who are not trained or educated for the new era. I believe that even the number of underemployed, 16%-17% of the work force, under-estimates the structural problem that exists. Thus, the estimate of 11 million new jobs that are now needed in the economy to get us back to where we were before the Great Recession began also under-states the problem.

Investment-wise, just as in the 1950s, the whole structure of opportunities available is changing from the earlier age. But, one needs to consider the new format of the economy that is evolving out of the manufacturing age in developing ones portfolio strategy. Similar to the 1930s, the 2000s are producing a modernization of the United States that will alter the world as it has been known and will produce a world that we can’t even hardly imagine yet.

Ecomonic Stimulus: Do We Need More?

When the history of the recent financial crisis and Great Recession is written, the basic conclusion that will be presented is that a financial crisis can be ended and a major recession turned around if the government throws massive amounts of money at the economy.

And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. The lead editorial in the New York Times this morning calls for additional stimulus: see “The Case for More Stimulus”, http://www.nytimes.com/2009/10/27/opinion/27tue1.html. The Times struggles to come up with legitimate proposals for additional spending and comes up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bails out with the claim that “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.

Spending is addictive. Once you start, it is hard to stop.

Another problem, however, is that it takes time for economic systems to work things out. Sure, a “cash for clunkers” program can goose up spending in August, but September turns into a bust.

Real programs take time because the programs not only have to be designed, resources have to be assembled, and the projects have to actually get started. Then the effects of the program must work their way through the economy. “Shovel ready” programs that have an immediate economic impact on a city or a region are really few and far between, as we have seen from the initial Obama stimulus package.

So, what time frame are we looking at for government stimulus to work its way through an economy? Maybe three to five years?

And, how do you measure the effectiveness of the government stimulus? The Wall Street Journal today attempts to provide some idea of how this question might be answered: see “The Challenge in Counting Stimulus Returns”, http://online.wsj.com/article/SB125659862304009151.html#mod=todays_us_page_one. The conclusion of the author of the article is not encouraging.

Then there is the question about whether or not these programs replace or reduce other programs that would have been undertaken at this time. This is the question of the multiplier effect of government expenditures: is it above one or below one. Some of us believe that the multiplier for government spending is below 0.5. Not a very good bang for your buck!

And, what happens when people don’t see any results, or, at best, minor improvements? They start clamoring for more and more stimulus as the New York Times does today. Frustration sets in and people over-react to the situation. They want results and they want them now!

Yes, people and families are hurting. Yes, communities and states and regions are hurting. We don’t like to see the pain and would like to do something about it.

However, sometimes you can only do so much to improve the situation. The abuse that got the economy into this condition leaves no good choices for us to choose from in attempting to get out of the situation.

Was this crisis due to a failure of modern economics? I agree with the economist John Taylor who has written that this crisis actually vindicates the theory developed by modern economics. The problem was that the crisis was created by “a deviation of policy from the type of policy recommended by modern economics.” He goes on to write, “In other words, we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economic theory went wrong. It occurred because policy went wrong, because policy makers stopped paying attention to the economics.”

The conclusion one can therefore draw from this is that continuing “interventionist government policies” may not resolve the current problems but only exacerbate them. For example, if part of the problem is that families and businesses used too much debt and this helped to create the financial bust, then increasing the amount of debt outstanding in the economy is not going to resolve the problem, but may actually make it worse.

Well, throwing everything including the kitchen sink at the problem may bring the financial collapse to an end and help the economy to bottom out. But, what happens next? What happens after this massive amount of money is thrown at the economy?

For this we don’t have an answer although the New York Times does. “Ongoing economic problems are a sign that stimulus needs to be bolstered. Deficits are a serious issue, but the immediate need for stimulus trumps the longer-term need for deficit reduction. A self-reinforcing stretch of economic weakness would be far costlier than additional stimulus.”

More! That’s the answer!

And, people actually say that the talk about all the deficits is harmful to the situation. We are creating massive amounts of debt, but we can’t talk about them? Come on!!!

But, what if all the discussion about future deficits is causing people to spend less? What if the discussion about future deficits is causing people to fear that the Federal Reserve will not be able to reduce the size of its balance sheet and keep money and credit from soaring? What if the discussion about future deficits continues to result in a decline in the value of the dollar? What if the discussion about future deficits weakens American bargaining power among the rising nations in the world, China, Brazil, India, Russia, and continental Europe?

Should we stop talking about the deficit?

Or should be consider that maybe, just maybe, more is not the answer.