Government Incentives Do Matter--Part II: US Home Ownership

Just saw another example of the role that government incentives play within an economy. 

On Friday, I took off on the interesting essay by Financial Times columnist Gillian Tett about the impacts that the regulatory declaration that European sovereign debt was “risk free” had on the European sovereign debt crisis. (http://seekingalpha.com/article/305431-government-incentives-do-matter-the-european-case)

The conclusion presented by Ms. Tett was that declaring the debt of a government as “risk free” results in too much government debt being issued because it is so cheap to issue it.  Continuing to maintain the “risk free” tag after it becomes obvious that the debt is no longer “risk free” just exacerbates the situation.  Too much sovereign debt gets issued and a financial crisis can result.

Within that post I pointed to another situation in which government incentives produce a result that inconsistent with the original goal of the economy.  I argued that the credit inflation policies followed by many western governments over the past fifty years to keep people employed and provide a buoyant economy so that the income/wealth distribution of the country can stay more balanced or at least not deteriorate has had the exact opposite effect of making the income/wealth distribution more skewed toward the wealthy end of the spectrum.

Today in the Financial Times there is a major article on the United States housing market. (http://www.ft.com/intl/cms/s/0/a05d2a58-0565-11e1-a429-00144feabdc0.html#axzz1d1bsytCm)

Included within this article is more evidence of how government incentives, created with the best intentions, have produced results that are inconsistent with the original goals and objectives of the government’s policy. 

The specific programs at issue in this article are those US government programs intended to bring home ownership to more and more Americans.  These governmental efforts were an integral part of the credit inflation program of the United States government over the past fifty years, in both Republican and Democratic administrations.

The housing programs of the American government appeared to be very successful for a long period of time and with the underlying credit inflation policies in place, it seemed as if this success would continue on unabated.  Not only could people own their own home, home ownership seemed to be the “piggy bank” that accounted most of the wealth increases being experienced by the middle class. 

This was income/wealth re-distribution at its best because it was achieved without any overt or explicit governmental policies aimed a achieving such a re-distribution!

The numbers: in 1960, approximately 62.0 percent of Americans owned their own home; in 2004 69.4 of all Americans owed their own homes.  And, it looked like this number would continue to rise for the foreseeable future. 

The government programs worked!

Unfortunately, the current number is slightly more than 66.0 percent. 

And, analysts at Morgan Stanley argue that the true number is around 60.0 percent because many delinquent borrowers who say they are “merely renting” homes will soon be forced to give these homes up.  Hence, the number of actual homeowners in the country is substantially over-estimated. 

Behind this argument is the fact that about 20.0 percent of homeowners are either unable or unwilling to make their mortgage payments. This is consistent with those analysts who predict that one in five borrowers will default in the near future.  This problem only places more pressure on the prices of homes to continue to fall. 

The actual rate of home ownership in the United States could drop below 61.0 percent in the next three- to five-years.  This estimate is attributed to Karen Weaver at Seer Capital Management.  The shrinking of the American middle class will only add to this decline.

Thus, the picture of the United States as “a nation of renters.”

Who would have thought?

The structure of the United States housing industry, as we know it at the start of the twenty-first century, was built on the foundation of the continuation of credit inflation as the basis of the government’s fiscal policy.  This credit inflation and the ease with which someone could become a home builder helped to account, not only for the number of builders that existed within the industry, but also the size of many construction companies that were able to achieve substantial scale in home-building.

This structure is changing and will continue to change in the near future. 

But, all the firms and businesses that supported this structure will also have to change.  Business, especially if America becomes that “nation of renters”, will have to change and this will include real estate agents, mortgage brokers, security bundlers, and so forth. 

This is not a philosophical question, it is a reality for hundreds, even thousands, of people who have worked in the real estate area.  What is going to happen in this area and how will this impact investment opportunity in the “housing” space?

But, perhaps even more important is the question about how will this situation impact the federal government and the federal programs and the incentives that they create?  Fannie Mae and Freddie Mac are insolvent and costing the American taxpayer billions of dollars.  Who is going to finance mortgages in the future?  Security bundling and packaging is under scrutiny and is going to change.  And, who is going to buy these mortgage securities in the future?  The Federal Reserve? The rating agencies have been under attack and there is a movement for government to oversee or control them.  And, how about the subsidy of construction... and the construction of low-income units…that the government has played such a large role it?

The governmental incentives related to home ownership are changing as it the behavior of the American public with respect to whether or not people want own their own home.  As individuals continue to de-leverage, home ownership does not seems to be such a desirable allocation of their income/wealth. 

Government incentives obviously are important.  But, as with most incentives, one has to separate the impacts of the incentives in the short-run from the consequences of the incentives in the longer-run.    

"We Don't Expect Americans to Fight Temptation"

Suggested reading for today: Gillian Tett’s piece in the Financial Times, “ECB rate rise will spark new debate about US tightening.” (http://www.ft.com/cms/s/0/e40ec032-613b-11e0-ab25-00144feab49a.html#axzz1ImD5RZZn)

She quotes a senior Latin American official in attendance at the recent annual meeting of the Inter-American Development Bank: “We don’t expect Americans to fight temptation” when the United States government has to make tough monetary and fiscal decisions. The speaker, Tett states, ended this statement “with a hint of the disdain developed nations used to deploy when discussing the third world.”

A specific concern is that United States monetary policy is flooding the world with liquidity and, in doing so, causing dramatic increases in commodity prices and asset prices.

Many countries in Asia and Latin America have responded with controls and other attempts at protection to stem foreign money coming into their countries via the carry trade. Brazil just imposed another round of controls this week.

Of course, Federal Reserve officials, including Mr. Bernanke, claim that the problem is “out there.”

American “officials insist it is poor local policy and excess savings in the emerging markets and not cheap dollars that are creating bubbles.”

And, anyway, a decline in the value of the dollar is good for America because the falling value of the dollar will make American goods cheaper in world markets and will help to improve the trade balance. Christina Romer, former Chairperson of the President Obama’s Council of Economic Advisors, just reiterated this claim when interviewed on national television this week.

Funny, but the statistics don’t seem to support this claim. Since the dollar was floated on August 15, 1971, the value of the dollar has declined by about 35 percent and the United States balance of trade turned negative in the late 1970s and, on an annual basis, has not been close to achieving positive territory since.

History does not support the conclusion that the falling value of a currency will improve a country’s balance of trade when that country is experiencing a period of sustained credit inflation.

Something happens to the production of a country’s goods and services when it is going through a period of sustained credit inflation. The productivity of that country declines relative to those countries that are not experiencing as severe a period of credit inflation.

For one, a country experiencing a sustained period of credit inflation will shift resources, building up finance and financial services at the expense of manufacturing. For example, about 35 percent of the output of the United States in 1965 came from the manufacturing sector. Early in 2011 this figure dropped to less than 14 percent. Also, exposure to risk increases during periods of sustained credit inflation along with increasing financial leverage and financial innovation.

Furthermore, in the United States the industrial use of capital declined from over 90 percent of capacity around the middle of the 1960s to around 80 percent at the last peak of capacity utilization. Capacity utilization now stands around 75 percent. The under-employment of labor also increases during such times. My estimates place under-employment of the American worker at around one in five people of employment age. I believe that over the next year or two this figure will not decline, even in the face of declining un-employment because of the wave of mergers and acquisitions that are going to take place.

The assumption of the economist that “everything else will not change” in the face of a declining value of the dollar does not hold. Yes, the declining value of the dollar does make American goods cheaper in world markets, but this does not account for the changes in the structure of the American economy when credit inflation pervades the nation for a fifty-year period. In the American case, the changing structure of the American economy has not helped solve the balance of trade problem.

The view from the “rest-of-the-world” is that the United States is not going to change its viewpoint. The United States has been able to act the way it has because it has had the “reserve currency” of the world and has been big enough to absorb the international capital flows that have existed over the past fifty years.

But, the United States fiscal and monetary authorities are in a battle now which, given their views, will not allow them act any differently than they have over the past fifty years.

They argue that government spending must be maintained or increased in order to put people back to work.

They argue that credit inflation must be forced on the American people so that the efforts of individuals and businesses to deleverage, to reduce the excessive leverage they had built in the past, can be offset and these individuals and businesses can get back to the process of re-leveraging so as to stimulate economic growth and reduce unemployment.

Ms. Tett speaks of the existence of the culture war between the European Central Bank and the Federal Reserve. Certainly, different worldviews seem to exist between the leaders of these two organizations.

But, it is the assumptions behind the worldviews that seem to be dramatically different and it is the assumptions that ultimately prove to be so important. The worldviews are derived from the assumptions, but it is the assumptions that people find so hard to give up because they become so personal.

As long as the United States continues to believe that the declining value of the dollar is good for the country, based on arguments similar to the ones attributed above to Christina Romer, and looks for excuses like “poor local policy” and “excess savings in emerging countries”, the leaders of the United States will continue to believe that it can proceed as it has for the last fifty years.

As long as the leaders of the United States continue to act as they have for the last fifty years then the value of the dollar will continue to decline.

And, the attitude toward American policymaking will continue to be: “We don’t expect Americans to fight temptation.”

The Deleveraging Continues

There are three major factors that will contribute to the timing and the strength of the economic recovery. First, there is the ability and speed at which individuals and businesses are able to get their balance sheets in order by reducing the amount of debt they have on them. Second, there are supply side questions about the restructuring of the economy. This has to do with the large number of people that have left the labor force and may not return in the near term and the secular decline in the capacity utilization of industry. (See my post of June 22, 2009, “Structural Shift in the U. S. Economy is Really in Supply”: http://seekingalpha.com/article/144508-structural-shift-in-the-u-s-economy-is-really-in-supply.) Third, there is the tremendous amount of debt the federal government is issuing and the fear that this re-leveraging will create a credit inflation that may go right into prices rather than output and employment.

In this post, I am primarily focusing on the first of these factors. I will discuss the progress of the second two issues in future posts. There is more immediate information on the first and it is vitally important that this deleveraging takes place in an orderly fashion or the near term concern over the latter two will be misplaced.

Perhaps the two most highly publicized methods of deleveraging continue to speed along at a rapid pace. The American Bankruptcy Institute has reported that the total number of bankruptcies in the United States filed during the first six months of 2009 increased by 36 percent over the same period of time in 2008. The only time bankruptcies have been so large is right before the bankruptcy law change earlier in this decade. Business filings during the first six months were up 64 percent over the first six months in 2008 and individual or household filings were up 35 percent.

Bank closings reached 81 for the year with four new banks added to the list on Friday, one of them being the 10th largest bank failure in United States history. Talk now is that there will be 300 or more bank closures in the near future. The FDIC is scrambling to find ways to increase its financial resources to handle the upcoming deluge of failures and is also easing restrictions on those that can bring private equity into the mix to carry some of the financial burden in taking over these failed institutions.

Getting less publicity is the effort that individuals and businesses are making to bring their own financial situation under control. Cutting expenses is, of course, one of the immediate ways that people can work toward their own best interest. Another way of saying this is that people and businesses are increasing their savings. Every week, more and more articles are appearing informing people how this saving might be accomplished and presenting stories of how households and companies are successfully meeting this challenge.

Furthermore, there are a growing number of stories of people and businesses getting in touch with those they owe money to and working with the lenders to set up terms and conditions that will increase the probability that debt will be repaid in a timely manner. My experience in banking supports the contention that financial institutions and other lenders really would prefer to work something out with those they have lent money to, but depend on those borrowers that perceive that they are going to face some difficulties in the future to get with them and initiate discussions about how things might be worked out. Postponing discussions only puts more pressure on both parties and tends to make things harder to resolve.

Refinancing is another problem looming on the horizon. There seems to be dark clouds hovering over the commercial real estate industry and less credit worthy corporate debt issuers. A lot of debt is going to come due over the next 18 months or so. The big concern is whether or not this debt will be able to be re-financed since very little of it will be able to be re-paid. The bits and pieces of news coming out of this area is that discussions are being held and although there may be failures coming out of these situations that the problems are recognized and will be absorbed in a relatively smooth fashion as time passes.

The areas of the bond market that contain firms with higher credit ratings are performing remarkably well. Volumes of new issues are up and the financial markets have absorbed these rather smoothly. If anything, corporations have turned to the bond market for funding since the commercial banking system is actually shrinking its base of commercial and industrial loans. This is an interesting thing happening to substitute bond credit for the credit extended by the banking sector at this point, but, as they say, whatever works.

Another method for de-leveraging that seems to be picking up steam is that corporations are buying back their own debt off the open market. In some cases it is reported that these companies can buy back their existing debt at 50 cents on the dollar which is a pretty good exchange for the company going forward. Look to see this pick up this fall.

Finally, the Federal Reserve does not look like it is going to pull the rug out from the banking system and the financial markets going forward. Yes, there is a lot of concern about all the reserves the Fed has put into the banking system and whether or not it is going to be able to “exit” the banking system in an orderly fashion. However, the Fed does not want a replay of the 1937-38 experience when it caused a collapse in the banking system by trying to withdraw excess reserves from the banks by raising reserve requirements. (See my post of August 21, “Federal Reserve: Exit Watch”: http://seekingalpha.com/article/157620-federal-reserve-exit-watch.) The best guess here is that the Fed will continue to keep the banking system very liquid in order to help underwrite the de-leveraging now underway.

The important thing to remember at this time is that “quiet is good”! The de-leveraging is taking place. However, the de-leveraging will take time. We just can’t become too impatient for we must let the system do its work and restructure its balance sheets. We just don’t want any more shocks! There still is a long way to go toward a full economic recovery and the other two issues I mentioned in the first paragraph are of great concern. But, we move forward by just putting one foot in front of the other.