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.    

Maybe Things Have Changed

During my professional career, three things have seemingly dominated the American culture. First, the labor unions; second, the manufacturing industries; and the third was home ownership.

I spent my formative years in Michigan and nothing dominated the newspapers more than the activity of labor unions and the car industry. That was just a part of the society there. Of course, there was the steel industry and in the case of unions there was the coal industry and so on. Nothing is more vivid to me than the role of manufacturing and labor unions in the culture of my youth.

If anything else came close it was the idea of home ownership and the suburban sprawl. It was especially important to put the returning soldiers into homes and to help them live the “true” American life.

These days are gone, but the role they played in this earlier existence still dominates our national life and our political philosophy. Maybe that needs to change. Maybe we need to re-direct our attention.

The manufacturing industries have become a smaller and smaller part of the United States economic machine…for better or worse. The economy has shifted toward information and “information goods”. An “information good” is broadly defined as anything that can be digitized. Besides the computer industry, three other major subcategories in this area are in financial services, higher education, and government. Finance, colleges and universities, and government deal, primarily, with information and “information goods”.

The “new” structure of commerce in the United States is tilted toward the more educated, the more mobile, and the modern urban community. The “old” structure relied more on physical effort, the stationary, and the suburban life.

That is, the driving forces in this new modern world are not cars, and steel, and manual labor.

The thrust of the labor unions has also changed and it seems as if unions have spread into the area of government as the presence of government has grown in the society over the last fifty years. Back in “the good old days”, unions were connected with industry and hard and dangerous jobs and “national” monopolies. International competition was not a threat at that time.

Today, the presence of unions has radically shifted. In the United States most union members are connected with government. This is also the case in the rest of the western, democratic nations. Labor unions are still important in the automobile industry, but the automobile industry is just not as important any more. I have seen figures that indicate that something like 60% of the membership in American labor unions these days is related to government. This move has completely changed not only the location of labor unions in the United States; it has also changed the focus.

The desire to get Americans into their own homes has been present in the country since the country was started. This was felt to be important not only for individuals themselves, but for the substantial positive externalities that were felt to accompany the growth of home ownership.

Today, we may find that renting may become more prevalent in the faster-moving, more educated, “urban” workforce of the 21st century. And, this mobility is becoming more global than just national.

The economic policies of the government have been built around the above factors which, I contend, are not as prevalent as they once were.

Monetary and fiscal stimulus were more effective in an age of “heavy manufacturing” because these industries relied upon fixed capital, huge plants and machinery, and a “local” labor force. When unemployment happened, labor stayed “at home”, both in terms of location, but also in terms of skills because the workers needed to know little else. Monetary and fiscal stimulus put these workers back to work in their old jobs as sales picked up. New investment also was created as the economy rebounded.

The same is not true in the Information Age. “Information” companies do not have huge plants and large machines to maintain. Downsizing and the shifting of the employees occurs incrementally and more rapidly than in the past. People move and re-train and change. Monetary and fiscal stimulus is not so effective because the companies and have “moved on” and do not re-hire people back into their old jobs as did the manufacturing firms. The employees have also “moved on”. Furthermore, these companies do not have large capital investments to undertake that help the economy to re-start.

The labor union issue is surfacing in another way. Labor unions connected with government workers have become very important in recent years and have been very successful in gaining large settlements related to health benefits and retirement. A recent edition of the Economist magazine has covered some of the issues here. The problem: “One California mayor estimates that the effective cost of employing each police officer and fireman is $180,000 a year. That sum is not their take-home pay. For police and firefighters, the big costs occur when they stop working—retirement at 50, combined with inflation-linking, health benefits and lump sums for unused sick leave…California is also shelling out fortunes to retired state and municipal managers; more than 9,000 have retirement incomes of over $100,000 a year.”

And, these pension promises have been subject to “Alice-in-Wonderland accounting.” The Economist presents figures that pension liabilities are estimated to be around $5.3 trillion, compared with $1.9 trillion of assets. “The total shortfall of $3.4 trillion is the equivalent of a quarter of all federal debt.”

So, when it comes to governmental employees, the fighting is not over peanuts. And, this is a worldwide issue as can be noted in the riots taking place in Greece, Italy, Portugal, Spain and France over their government’s retirement and pension payments. And, yesterday it was revealed that the new austerity budget of the British government contains a reduction of 500,000 public sector jobs. “Today, the fight begins,” states the general secretary of the largest government union in the UK.

The role of labor unions in the 21st century society seems to need to be re-addressed going
forward.

Finally, the pressure of the government to achieve high rates of home ownership must be re-visited. We, in the United States, have paid a major price for the emphasis placed on this goal and the resources that were allocated toward its achievement. Payment is still coming due in the area of foreclosures, commercial real estate bankruptcies, and the resolving of government support of Fannie Mae and Freddie Mac. It is very likely that we, the people of the United States, will be paying for this bailout for many years to come.

The whole point of this post is to argue for a change in some of the assumptions behind the economic policies of the leaders of the United States government. The world has changed. Maybe our leaders need to change their outlook as well.

Or, is that too much to ask?

Households Continue to Suffer

I’m trying to make sense out of the economic recovery. According to a growing number of people the Great Recession ended in July 2009 or, at least, somewhere in the third quarter. There continue to be “green shoots” that are popping up here and there.

Still, I am uncomfortable. I’m usually a pretty optimistic guy and I don’t like being considered as a “gloomy Gus”. But, some things in the economy continue to nag at me.

Households, at least how we used to know them, are having a difficult time. The major issue remains employment…or unemployment. However, another issue that can’t be ignored and that will impact employment patterns over the next five to ten years is the restructuring of industry and commerce. Restructuring often requires changes in skill sets and changes in geographic location.

In terms of employment we have just learned that companies in the United States cut an estimated 22,000 jobs in January, according to ADP Employer Services, the smallest decline in two years, and much lower than the recorded 61,000 decrease in December. The January result showed that 60,000 jobs were lost in the goods-producing area but in service industries 38,000 jobs were added to payrolls, the second consecutive increase. This was not a bad result, but employment is still declining. (http://www.bloomberg.com/apps/news?pid=20601087&sid=a01taizONkz8&pos=3.)

Most estimates for the unemployment rate in January remain in the 10% range. Very little improvement is expected in this measure in the first six months of this year. Furthermore, the projections of the unemployment rate used by the Obama administration in the budget proposals released this week are anything but encouraging.

These figures do not include numbers on discouraged workers who have left the labor force or those individuals that are working part-time but would like full-time employment. The rate of underemployment in the United States is in the neighborhood of 17% and is expected to remain around this level for the foreseeable future.

One of the reasons for underemployment to remain this high is the restructuring of industry and commerce that is going on in this country. As I have reported, capacity utilization in the manufacturing industries remains quite low and has not even come close to returning to 1960s levels in the past 40 years. (http://seekingalpha.com/article/185801-hearts-minds-and-recovery.)

The trend in United States manufacturing has been downward for a long time as industry has shifted from the heavy sectors to areas that produce higher-tech products. Some industries, like the auto makers, have had to decline due to diminished demand in the United States. Other industries, like chemicals, are relocating labor-intensive operations to other countries.

From December 2008 to December 2009 there have been large declines in capacity in the United States in areas such as textiles, printing, furniture, and plastics and rubber products. Industries where substantial increases in capacity have taken place are the producers of semiconductors, of communication equipment, and of computers. Shifts like these have major impacts on labor skills and the location of employees. (http://online.wsj.com/article/SB10001424052748703338504575041510998445620.html?mod=WSJ_hps_LEFTWhatsNews.)

It is important that these shifts take place. One of the problems with job stimulus packages sponsored by the federal government is that they tend to ‘force’ people back into the jobs that these unemployed have lost. This is not good because it reduces the incentives for industries to change even though it generates revenues for producers, like car manufacturers, and income for workers, like autoworkers. However, industries that need to change must change some time and postponing the change only exacerbates the magnitude and pain of adjustment. Need I mention the United States auto industry again?

This change is being reflected elsewhere and it has an influence on how political power is distributed in a country. The number of American workers that are in labor unions has been experiencing a downward trend that mirrors the decline in United States manufacturing. What is additionally interesting is the shift that has taken place within the overall union workforce: in 2009, public employees that are members of a union rose to more than 50% of total of all union workers. The decline in union membership connected to the manufacturing sector has been hidden because of the rapid growth in those connected with government employment. This is just another indication of the restructuring of the labor force. (http://online.wsj.com/article/SB10001424052748703837004575013424060649464.html.)

Added to this is the large shift that has taken place in home ownership in the United States. Home ownership peaked in the United States in 2004 when 69% of all Americans owned their own home. This peak was reached through the emphasis placed on home ownership in the United States, government programs to get people into their own homes, and low interest rates.
However, this rate has fallen to 67% at the end of 2009 and is expected to continue to decline as people lose their homes through foreclosure or bankruptcy. The rate of home ownership could fall into a range of 62% to 64% that was the case in the early 1990s. This represents a massive shift in the asset holdings of United States households for homes are still, by far, the largest asset held by households in America. (http://online.wsj.com/article/SB20001424052748704022804575041083721893188.html#mod=todays_us_page_one.)

This continued decline does not seem unreasonable given the hard facts facing many homeowners in the United States. In the third quarter of 2009, 4.5 million homeowners had seen the value of their homes drop below 75% of their mortgage balance. This figure is projected to hit 5.1 million, or 10% of all homeowners, by June. Research has indicated that this 75% figure is the level at which people really consider walking away from their home. (http://www.nytimes.com/2010/02/03/business/03walk.html?hp.)

These numbers make me feel uneasy…and that is an understatement. The basic reason for feeling uneasy is that I don’t see a “normal” economic recovery reversing these trends. The United States is restructuring from the excesses of the past, of “forcing” industry to not modernize, of “forcing” people to become homeowners, and so forth and so on. It is always the case that restructuring takes place: sooner or later. Now, seems to be OUR time!

The problem is that this restructuring has ramifications for other areas of the economy. Small- and medium-sized banks have lent money to these home owners and they are the ones that these households will walk away from if they leave. Commercial real estate developers will also walk away from the banks, maybe more easily, as we have seen, than the households themselves. Many businesses that are restructuring or downsizing will not be borrowing from the banks so business loan demand will stay low. And, one can think of many other areas in which repercussions may be felt.

I like to be optimistic about things, but I can’t get these “less-than-happy” conditions out of my mind.