Wednesday, December 31, 2008

How much do U.S. households have to de-lever?

In a comment to this entry, MSmith notes that the consumer has not “started to de-lever in earnest”. While it seems obvious that households, particularly in the United States, have over-borrowed, knowing by how much and how much needs to be unwound is a tricky question.

In my mind, the easiest way to understand the over-leverage of the U.S. household is to look at the ratio of consumption to GDP. This number is essentially the amount of U.S. income devoted to consumption as opposed to investment or exports. The higher this number grows the more households have borrowed to support their consumption.

The share of income allocated to consumption in the United States has risen from 62 percent in 1980 to over 70 percent in 2008. Over 40 percent of the rise has occurred since 2000. This level of consumption is way too high. It is high by historical post-war U.S. standards and it is high by contemporary international standards.

Take a look at the inset box. Of the major industrial economies, the United Kingdom has the highest ratio. At 64 percent of GDP, however, the United Kingdom has only reached levels of consumption similar to that of the early 1980s United States.

To make a stronger link with leverage, one can glean similar insights from the current account deficit of the United States. Over exactly the same period that consumption as a share of GDP has been rising, the current account deficit of the United States has been falling. The match is close even to the point of matching the three percentage point jump since 2000. The current account deficit represents real indebtedness to foreign economies. It does not matter whether this debt is incurred because oil prices have risen or because we buy a lot of TV’s.

The share of consumption to GDP in the United States must fall and it seems that we are, finally, at the turning point. There are only two ways for this adjustment to occur: either consumption must fall or the other components of GDP must rise.

How far does consumption have to fall? It depends on how far the ratio of consumption to GDP must move. I believe the ratio is likely to return to 1980 levels but a strong case can be made that the ratio need only fall back to the level of the late 1990s.

Assuming no growth in other components of GDP, consumption would have to fall 3.2 percent per year to bring the ratio back to its 2000 level within five years. For the ratio of consumption to GDP to fall back to its 1980’s level within five years, consumption would have to fall 7.4 percent per year. If we allow 10 years for the ratio to return to its 1980’s level, consumption only needs to fall 3.2 percent per year.

These falls are huge and well beyond anything in the modern historical record for industrial economies with the possible exception of the Great Depression. Only Argentina (and perhaps some of the Asians during the Asian Financial Crisis, though I have not checked) suffered falls of this magnitude. In 2001 and 2001, Argentina experienced repeated double-digit falls in consumption.

Of course the consumption numbers are all relative to the other components of GDP. Consumption does not have to fall as much if other parts of the NIPA accounts are growing. However, because consumption has such a large share of output, the other components would have to grow very fast indeed to keep consumption from having to fall at all. In addition, I have trouble imagining components like investment expanding when consumption is falling at these rates (see the next section).

These numbers are scary.

Implications for House Prices? By the way, the large fall in consumption has significant implications for house prices. Assuming that there is no downward adjustment in the housing stock, a back of the envelope calculation indicates that house prices have to fall 38% along this (1980) adjustment path, with the first 19% occurring in the first five years.

(Technical note: The back of the envelope calculation is derived from a Gordon-Growth decomposition, assuming log utility and constant interest rates. With log utility, the level of the interest rate does not matter. I also ignore changes in population size. This is essentially a poor man’s version of the techniques used in this Fed paper. )

Again, these numbers seem quite large. But, perhaps by coincidence, these are exactly the numbers experienced in Japan during its economic collapse in the 1990s. Between the peak in house prices in 1992 and 1997 Japanese land prices fell 19.4 percent. Between 1992 and 2002, land prices fell 37.7 percent. The numbers are not rigged or preplanned, nor are the dates carefully chosen. They just turned out exactly that way.

Another 20 to 30 percent fall in house prices from where we are now is not beyond the realm of possibility.

Implications for Other Asset Prices? MSmith’s original question was on the implications for investment. Here I am on shakier ground but the Gordon Growth model was originally intended to analyze equity prices. The same analysis should then essentially apply. Stock prices are in for a rough ride.

Let’s stick with the theme of comparing the current U.S. situation to the Japanese situation in the 1990s. Japanese equity markets peaked in 1989 and following the peak, the fell, on balance, for the next 15 years.

Below I have plotted Japanese stock prices against the Dow and indexed them both to 100 in their peak year. For the Dow, the chart starts in 1985 and runs through year end 2008. The Nikkei line starts in 1967 and also runs through year end 2008. In other words, the two time series are shifted such that their peak dates match.

With consumption likely to fall and the demographic situation continuing to worsen, U.S. equity markets are going to have a hard time outperforming Japanese equity markets of the 1990s.

I hope I am wrong, but we shall see.

Friday, December 19, 2008

The Stealth Bailout

Over the last three months, the balance sheet of the Federal Reserve has exploded. While Congress debated the $700 billion TARP and later the $35 billion request from the auto companies, the Fed has quietly lent, directly and indirectly, over $1.3 trillion to banks, firms, money market funds, and foreign central banks. This is real money. The increase in the balance sheet is over 10 percent of GDP. To put this number in further perspective, the Bank of Japan during its entire five-year Quantitative Easing Period, expanded its balance sheet by around 6 percent of GDP; and at the time, the BOJ’s actions were considered large (see this note from the SF Fed). This is a bailout; it is not a temporary lending program.

Two programs make up over half of this expansion: the Term Auction Facility (TAF) and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity (ABCP MMF). Both of these programs were implemented in an attempt to foster liquidity in the lending market. Both of the programs swap assets from private-bank balance sheets and put them on the Fed’s balance sheet. The first program is designed to take assets off bank balance sheets, holding them in the Fed’s vaults until markets “normalize”, potentially allowing the banks to lend more, especially to each other. The second program is designed to try and breathe some life into the ABCP market.

There are two principal problems with the Fed’s program. First, the sheer size of the balance sheet puts taxpayers at substantial risk. Second, the Fed’s purchases are distorting the market and preventing market solutions for some of these problems.

Balance Sheet Risk: Although the loans are collateralized, they are non-recourse. Essentially, this means that if the assets go bad while the Fed is holding them and the bank decides not to pay back the loan, all the Fed gets to do is keep the worthless assets. If the Fed were taking only the safest assets maybe this would be a good idea, but the list of collateral accepted at the discount window is stunning.

Take a look at the spreadsheet on this page. The sheet lists the collateral acceptable for the TAF. The list is long and I don’t want to give a full rendering but here is my key takeaway: the Fed treats U.S. Treasuries on the same footing as Municipal bonds, asset-backed securities, and mortgage-backed securities (both private label and agency). Either the Fed thinks the U.S. government is likely to default or they are overvaluing some of the other assets. Even scarier, the Fed will accept securities for which there is no market price, taking them on at between 60 and 80 percent of their face value.

Default rates on some of the assets the Fed is accepting are very high. Some of the assets might be safer than they appear, but I have a feeling that the banks are going to err on the side of handing over their worst assets, keeping the safest on their own balance sheet. For example, even though the Fed accepts U.S. government securities as collateral, the banks are not using their store of Treasuries as collateral. Even as the Fed’s balance sheet has expanded, its holdings of U.S. government securities fell by almost half, from over $800 billion to under $500.

Because the Fed’s balance sheet is now so large, very small default rates can lead to very large losses. If only 1 percent of the assets held default, the Fed would lose close to $13 billion. In truth, the default rate is likely to be much larger. And, we will likely never know the full extent of losses. Because the Fed does not publish its counterparties, it can hide even substantial losses. Given the mix of collateral, it is beyond the pale that none of the assets currently held have defaulted, yet the Fed has not disclosed a single loss.

Market Distortion: Most of the emphasis so far on distortions has remained in the arena of moral hazard: if you bail out companies, they will take riskier positions in the future. The market distortion I worry about is more subtle and more important.

The Fed is working in markets that are not functioning well. Many of the assets held by the banks, especially the ones without market prices, have fallen in value. The Fed envisions its purchases of these assets as supporting the market and adding liquidity. However, if the assets are actually being sold at too high of a price, the Fed’s purchases do not induce private parties to step into the market: the Fed’s actions preclude a private market.

Even if there is just a possibility that the assets have declined in value, the Fed becomes the only viable market. Private buyers will only purchase the assets at a discount. Private sellers don’t need to discount the assets because the Fed will take the assets as collateral at near face value. The normal market process cannot proceed as long as the Fed remains active.

The Fed’s commercial paper program is an excellent example of this effect. Since the end of October, the Fed has accepted $318 billion of asset-backed commercial paper. Over the exact same time period, asset-backed commercial paper outstanding rose only $43.9 billion. Private holding of the paper have actually fallen by $275 billion—one-third of the total fall in private asset-backed commercial paper has occurred since the Fed began its purchase program less than two months ago. At the very least, the Fed’s program is not helping and it is likely hurting price discovery.

More importantly, because the Fed and the Treasury have been so aggressive in expanding their programs, the market distortion extends to assets they are not currently buying. It seems that no class of assets is permanently off the table.

Why sell at a discount if the Fed might begin buying the asset next month? The housing market is the best example of this effect. We will get hard data over the next week, but anecdotes indicate that home purchases fall sharply in November. I believe one of the main reasons was the indication from Treasury that they might begin a program to force mortgage interest rates on housing purchases down to 4.5 percent.

In the face of temporary uncertainty (whether policy driven or macroeconomic), postponing sales, purchases, and investment is often an optimal strategy.

Takeaways: While Congress and the White House have been focused on the implementation of TARP and the debate over whether or not to bail out the car companies, the Federal Reserve has quietly been conducting the largest bailout in the history of the United States. The program might be helping the U.S. economy, it might be creating terrible long-lasting distortions, or it might be actively hindering adjustment. I don’t know, and to a large extent without more transparency, the answer is not knowable, especially without full disclosure.

I will add two thoughts.

Since the Fed has implemented the program the economy has gotten noticeably weaker. Signs of macroeconomic stress have become omnipresent. We do not know the counterfactual, but it seems to me that the burden of proof lies on those who believe the economy would have deteriorated even faster in the absence of the Fed’s actions.

The Fed needs to stop treating this recession as a liquidity crisis. If we were merely facing an ordinary liquidity crisis, the Fed’s actions should have already worked: liquidity crises like bank runs are easy to resolve. Firms and Banks need to take a realistic look at their balance sheet, mark down assets that still have some value, and write off the rest. Some institutions will go bankrupt as a result but those firms are already bankrupt they are just refusing to admit it and are staying in business only with large fiscal transfers. (By the way, NorthGG is one of the strongest advocates for this adjustment in prices. I recommend reading his comments here.)

Tuesday, December 16, 2008

Demographics and Jobs

Take a look at this interesting picture sent in by NorthGG. It shows the month on month gain in non-farm payroll (NFP) against the twelve-month growth in the workforce. I know workforce growth is somewhat endogenous, but nevertheless, the relationship is good with workforce growth lagging just a bit behind jobs.

I take away two lessons from this picture. First, and by far the most important, demographics matter. In the 1970s, the first cohort of baby boomers is just entering the workforce en masse. As a result, independent of the point in the cycle, workforce growth is relatively high. This means that equilibrium job growth also has to be high. By the 2000s, the first cohort of boomers is starting to retire. Equilibrium job growth is low. Losing 500,000 jobs in 1970 is different than losing 500,000 jobs now. Since fewer new entrants need jobs, we need fewer created jobs each month. 500,000 lost jobs creates a smaller "jobs gap" now than it did in 1970. Its still bad, just not as bad as it used to be.

Second, workforce growth lags the cycle a bit. We should not expect to see the bottom in terms of job losses until the twelve-month growth rate of the workforce starts to plummet to zero. I see a little bit of downward movement in the picture above but not a nosedive. We are not yet at the bottom.

Thanks again to NorthGG for sending in the intriguing picture. I will point you toward three interesting economic papers on demographics. First, a recent paper in ReStat studies the relationship between productivity and demographics. Second, Mankiw and Weill explained the 1990s downturn in house prices using demographics. This issue is explored further in a Fed paper from a few years ago. I like the way this paper compares the situation in the United States to that in Japan.

I believe the effects of demographics, in particular the effects of exogenous fertility shocks on the labor force, are among the most understudied factors in economics. Of course, many economists don't believe fertility shocks are exogenous. They are probably right.

Sunday, December 14, 2008

Stimulating Output: What can fiscal policy do?

In a comment on this post, Lisa asked
What would effective government spending by the Obama Administration look like? Is it providing targeted tax credits? Or are there specific infrastructure plans that might work in the short-run to stimulate the economy? What would an effective economic stimulus plan look like?

Lisa asks the right questions. Here are my thoughts on government stimulus and what Obama can do if he wants to stimulate the economy.

What can the government do to stimulate the economy? Not much, at least not directly. The government faces two fundamental problems:
1. Government spending reduces resources available to the private
sector. And, of course, every penny the government borrows to pay for
those resources must be repaid by that same private sector.
2. To be stimulative, government spending has to occur when the
economy is getting worse not when it is recovering.
Government Spending Reduces Resources: This is essentially the “crowding out” argument and I am aware that this point is hotly debated amongst economists. (See Nobel Laureate Paul Krugman for a strong proponent of the other side. We disagree in this case but he is one of the best economists around and he is worth a listen.)

The argument gets complicated and people start drawing IS-LM curves but here is the simple way to think about it. The amount of goods and services available in the economy at any moment in time is essentially fixed. If they government takes some of those goods, whether it’s steel to build a bridge to nowhere or paper to bind the thousand-page report on its policy, those goods are gone. They are no longer available to the private sector.

If somebody wants the steel, they have to outbid the government. In general, no private-sector firm can outbid the government and so they must outbid another firm: one of them loses and can’t complete their project.

The increase in price caused by government intervention can prevent price adjustment in key sectors. Booms are characterized by some goods becoming overpriced and busts are characterized by some goods falling in price. This price adjustment must occur for the economy to recover. Imagine how long adjustment might have taken if the government had tried to maintain the price of the fiber optics networks during the 2001 recession.

In addition, the government is distorting the amount of goods available for private consumption today relative to what is available in the future. As a result, interest rates rise. (This rise in interest rates is exactly what Krugman is going for when he recommends fiscal policy as a way out of a Liquidity Trap, a subject I will return to in a future post.) The increase in the real interest rate reduces private investment across the board. Investment is lower even in industries whose inputs the government is not consuming.

Government Spending Must be Well Timed: The crowding out effect always exists but the gains of government spending may outweigh the costs if the spending is implemented during the downturn. As a rule, the government should only interfere in the economy when it can do something better than the private sector and when the rate of return on that something is higher than the private rate of return.

As the economy enters recession, the rate of return on private investment is low. The probability of the government’s rate of return exceeding the private rate is higher. This return advantage disappears as the economy begins to recover.

Large spending programs take a long time to implement, making it difficult to time the downturn.

What Should the Government Do? The above problems are one of the reasons economists like tax cuts as stimulus. In a sense, a tax cut is not stimulating the economy but is removing a distortion that keeps the economy from growing. A tax cut send a relatively small amount of money to a relatively large number of people. At least some of these people will be able to respond to the cut. With an investment tax cut, some business is ready to build. With a consumption tax cut, some household is ready to buy that new water heater.

Choosing the right tax cut is tricky. Cutting investment taxes or dividend taxes, yet again, is probably not going to work. The return on investment is low at the moment; the marginal increase implied by the tax cut likely won’t matter. Plus, the Bush administration has already milked this cow.

In my mind, the best place to cut taxes right now is on labor income. Right now firms don’t want to hire labor because it is too expensive. Likewise, some workers don’t want to take a pay cut and so may not be working. Cutting the income tax is an easy way to hit this margin.

The problem with this plan, according to common lore, has always been that most workers don’t actually pay much income tax. This logic, however, is wrong. Every worker in the country pays the regressive FICA (social security) tax. This tax amounts to about 14 percent of income for low-income workers.

Suspending this tax works on two margins. First, taxes are cut on the group that appears to be struggling the most. Those who are struggling the most are also the most likely to spend the money in the near term. Second, with this tax lower, workers want to work more and firms want to hire more.

What Can the Government Do Without Cutting Taxes? Well, the same principal can be used with the states. Any substantial increase in infrastructure or education program is actually implemented at the state or municipality level. Give every state something like $2 billion dollars and make the transfer expire at the end of the year. I guarantee those states can find a use for the money. Some of the states will repair roads and bridges or they may use the money to implement already pending projects. Others will build schools or rebate the transfer to their own citizens. It does not matter. The state will use the funding in a manner that works best for them.

Thursday, December 11, 2008

Could We Lose 1,000,000 December Jobs?

Odds are still against it, but it is looking more and more likely.

Unemployment insurance claims are the single best timely indicator of the state of the economy. Although the week-to-week and even the month-to-month fluctuations can be misleading at times, if this series is trending, that's where the economy is headed.

Take a look at the picture below. I graph weekly unemployment insurance claims from 1967 through this morning's release -- 573 thousand. Claims have been trending up for a while now. Continuing claims look even worse. They are now, 4.4 million, only 6 percent below their all time weekly record set in November 1982. That's almost within the sampling error of the series.

We might be inclined to discount this week's number a bit. We already knew the labor market was bad. Plus, the weeks between Christmas and Thanksgiving have always been hard to seasonally adjust, what with Thanksgiving moving around every year. But, whether or not this week's number is real, the trend is solidly up and it is nothing but bad.

The job market is deteriorating. How bad is going to be?

Let's take a look at the relationship between initial claims and the monthly change in employment. We have a consistent series for each going back to 1948. The relationship between the two series is one of the most stable relationships in macroeconomics. It survives recessions, booms, the 1970s, and even the Great Moderation. If anything at all, the month-to-month movement has gotten stronger over the last twenty years.

Take a look at the chart below. The relationship holds up all the way back.

Now comes the scary part. My model claims-based model of employment spits out a December fall of 933,900!! That's within spitting distance of a million. It looks like we are in for a bad couple of months. Hold on to your hats.

Caveats. Of course, the 933,900 number comes from holding initial claims in the first week of the month constant for the rest of December. The risks to the forecast go both ways here. It would also be a monthly fall 30 percent larger than any other fall in U.S. history. That in itself argues against the number. In percentage terms, however, the number is not all that big. The labor force has grown a lot since 1974; we may have room for a large fall.

We shall see. But, it looks like a lot of folks are going to have a less-than-merry Christmas.

Tuesday, December 9, 2008

Hope for the Housing Market

And, if there is hope for the housing market there is hope for the economy.

Almost three years into the housing downturn (remember Housing Starts first turned negative in January 2006), the inventory of new homes for sale is finally starting to adjust in a meaningful manner.

Take a look at the picture below. As is typical during any stock adjustment, inventories rose during the first few months of the downturn. What is not typical is the behavior of the stock of unsold homes over the next 18 months. Inventories of homes for sale did not decline whatsoever, on average, between January 2006 and the summer of 2007.

Of course, as we have learned with so many series during this recession, falling to a low level does not mean the series is near the bottom. I don't have a crystal ball, but we can look at the series during previous downturns and make judgements about where it is likely to end up in this downturn.

Here is a long time series of houses for sale.

Housing inventories have a long way to go before they finish their adjustment, but the end may be in sight. If the number of homes for sale continues to fall at its 2008 average pace, the inventory of unsold new homes will hit its bottom (maybe 250k?) in March 2010 or in about 16 more months.

I am assuming that inventories only need to fall as far as they did during the 1982 downturn. As of right now, this recession looks worse than that one so it may have to fall farther but this number feels right.

The number of months left seems very large. That is why inventory overhangs are such a problem--remember the fiber optics networks in 2000. But, even if I use a much larger number for adjustment, we still need several months to work through the excess. For example, if I use October's monumental fall of 8 percent, the inventory adjustment takes another 6 months. No way am I that optimistic.

There is a silver lining, however, even in the 16-month adjustment scenario, my base case.

Housing starts stop falling long before the inventory adjustment is complete (see chart below - starts are the jagged black line). In every previous housing-market downturn, housing starts stopped falling about one full year before the inventory of new homes reached its bottom.

And, once housing starts stop falling so does the labor market. This means in about three months (four more labor reports), sometime in the very early spring, the labor market will stop getting worse: we will reach the worst of the month-on-month declines. A few months after that employment will start growing again. According to this forecast, we will see positive job growth as soon as next summer.

Does this mean the recession is going to end in mid-2009? Maybe.

Maybe not. All of the above is predicated on this downturn looking something similar to all of the other post-war recessions. The gorilla in the room right now is the large number of foreclosures. These foreclosures are adding to housing inventory in a manner very similar to new housing (they are empty and must be sold) and the number of foreclosures is at record levels. Therefore, these estimates may be wildly optimistic. My guess, and it is nothing more than a guess, is that the foreclosure crisis is good for about 4 to 6 months extra adjustment.

We shall see.

Monday, December 8, 2008

Bad News for the Foreclosure Crisis

Take a look at this chart released by John Duggan from the OCC today. (Here is Duggan's speech.)

Let me explain, the OCC asked lenders what percentage of borrowers re-defaulted on their mortgages after modification was complete, and how quickly did they do so? The chart shows the results. Each point of the line represents the number of borrowers who were thirty or more days delinquent following loan modification.

The results are stunning and unambiguously bad news for all of the loan modification plans out there. One-fifth to one-quarter of all modifications slip immediately back into default; that is, thirty days after modification they are thirty days behind. By six months, 50 percent of the borrowers are delinquent. The upward sloping line indicates that, at least on average, they are never returning to good status. No wonder the loan industry has not been enthusiastic about working out mortgages: Loan modification does not work.

Importantly, we do not know why the modifications are failing. The OCC is following up with lenders now trying to answer this question. In his speech, John Duggan offerred the following thoughts:
Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?

So, we need more data to distinguish between the different possibilities, but let me offer a speculation of my own: many of the borrowers remained underwater after the modification. Even the best modification plan, the Hope for Homeowners, the most the principal is ever reduced is to the value of the home. This means the borrower who would rather sell than default must come up with 6 percent or so of the value of his home, in cash. For the rest, what difference does it make if the lender lowers the interest rate a few percentage points if the mortgage is still worth way more than the house. There is no monetary incentive to make payments.

There is no easy, free solution to the crisis. Home values have fallen and they are likely to fall a lot further. Falling prices mean more foreclosures and more foreclosures mean falling prices. I am still on the fence as to whether we should bail out banks and homeowners by stopping the foreclosures, but if we are going to do it then get it right. It takes a fiscal transfer from good, reliable, safe households to households that recklessly over borrowed. The transfer has to be sufficiently large that the household is above water after the modification.

Sunday, December 7, 2008

Averting the Foreclosure Crisis

Many plans for resolving the foreclosure crisis are circulating at the moment. Both the Federal Reserve (MBS purchase plan)and the Treasury (Paulson speech) are working to boost the housing market, indirectly reducing foreclosures, by lowering mortgage interest rates. Sheila Bair, Chairman of the FDIC, wants to restructure housing debt so distressed households can afford their mortgages (read her plan here). The congress has its own set of initiatives.

None of these plans are going to work to resolve the foreclosure crisis let alone bring the economy out of recession.

The mortgage crisis started because too many households borrowed too much and bought houses they could not afford. Real money flowed into the housing market and residential investment increased. Because we couldn’t build enough, especially in urban areas, the price of houses rose. In this sense, we had not a housing bubble but a borrowing bubble (remember American households borrowed for much more than just houses: cars, big screen TVs, groceries …).

The borrowing bubble has burst. The money that flowed into the housing market is gone. There are now too many houses and house prices have to fall. This adjustment process is well underway. Housing starts have fallen off a cliff and house prices are falling. Prices are anywhere between 5 and 40 percent below their peak depending on where you live and which measure you believe. They are going to be lower.

The more prices fall the more households are underwater—they owe more on their home than their home is worth. These are the households who are most likely to default. These households may continue making payments for a period of time but their incentive to make payments is diminished. If their house price falls more or if they lose even a little bit of income, they are likely to default.

Any successful mortgage plan must address this issue first. The following plan would resolve the foreclosure crisis and eliminate one source of extra downward pressure on house prices (although it would be unlikely to end the recession).

  • Voluntary program to purchase all mortgages with a loan-to-value (LTV) ratio greater than 90 percent and issue a new mortgage with a 90 percent LTV to the household: This ratio gives homeowners an immediate financial stake in their property. A household with 10 percent equity in their home does not have a financial incentive to default. Even after closing costs and paying off the equity claim (see below), they are better off selling than walking away. A few households will still default but a few defaults are not a problem.

    With this plan, the government does not need to make an affordability determination. The household’s income does not matter. If they can afford their payments, they will make them. If not, they can sell their house for a small profit. This has the added advantage of minimizing forward-looking housing market distortions. Households can freely sell their house and housing market adjustment is not hindered by negative equity households.
  • Determining House Value: The most difficult part of this plan is determining the house value. But, this is a macro program—we care about the health of the economy not individualsso, we only have to be correct on average. The current value of the home can be estimated by using the price of the home when it was last sold combined with the average change in house prices for the MSA as measured by the OFHEO house price index. Allow the household to increase but not decrease the current declared value.

    Because none of the house prices indexes is perfect, especially at the MSA level when there is very little volume in the housing market, the government should evaluate the average home value periodically. If homeowners in the plan cannot sell their houses at the declared value then the average declared value is too high and must be reset.
  • Issue an equity claim: As with any government intervention in markets, this plan is a transfer between households. Responsible households are subsidizing the houses of those who over borrowed. It also encourages future households to borrow more in the hope they will receive a bailout if things go bad. Issuing an equity claim reduces both of these distortions.

    The equity claim recovers 30 percent of the difference between the origination value of the new mortgage and the eventual selling price of the home. With this percentage, the household stands to gain about 1 percent of the value of his home after closing costs at the time of origination.

    The equity claim, which is worth 3 percent of the home’s value at origination, also reduces take up of the program and provides an incentive for households in the program to increase the declared value of their property, thereby taking on a larger mortgage.
  • Program Cost: Of course, the cost depends on take up rates but the plan should not be expensive (compared to other initiatives currently underway). Outstanding mortgage debt increased almost $4 trillion between 2005Q1 and 2008Q2. (If a house was purchased before 2005 chances are it is above water.) Even assuming that every one of these households had a 100 percent LTV at purchase and that house prices are now 10 percent below the peak, the cost would only be at most $400 billion and it is likely to be much lower.
This is the simplest plan that would resolve the foreclosure crisis. It requires very little private information (mostly the mortgage value). There are good elements to the other plans and those elements can be combined with this plan. For example, with rising job losses one may fear that too many houses would flood the market at one time even under this plan to allow an accurate picture of local house prices. In this case, the above plan could be combined with a temporary payment holiday for high LTV households or even an outright foreclosure moratorium. Either would help meter the houses onto the market.

But, no matter what bells and whistles one adds to the program, a successful program must ensure that households remain above water. They must have an equity stake in their property or they will (on average) default at some point.

Saturday, December 6, 2008

Obama's Economic Stimulus

Welcome! This is the place to talk about the economy.

Let's get started. In his radio address today, Obama announced the key components of his economic stimulus plan. I am shocked. During the campaign, Obama and his team put together a sound economic plan. Take a look at the campaign web page. Many of these ideas could easily be turned into components of a real, workable, and immediate economic stimulus plan. He has good ideas. Yet, not one element in the details released today will provide any near-term economic relief. Here are his five key elements and my thoughts on each.

1.) Launch a massive effort to make public buildings more energy-efficient. Energy efficiency is an important goal. Changing the light bulbs in federal buildings won't save the economy. Replacing old heating systems might, but it takes years to plan and implement. It's seems like this was more important before the collapse of energy prices. Still, if the President Elect wants to promote energy efficiency and stimulate the economy, a federal tax credit on energy efficient home heating systems might work. By the way, this plan was first announced in August (see the bottom of page 7) as a small piece of the New Energy for America Plan.

2.) The single largest new investment in our national infrastructure since the creation of the federal highway system in the 1950s. I have to back off a little. This is real government spending and there is no question about the need to renovate our transportation infrastructure. And, some of this spending can be done quite quickly. Many states have projects on the books ready to go but "the single largest new investment ... since the federal highway system" will take time (years) to implement. How long does Obama think the recession is going to last? If the spending hits when the economy is trying to recover, it is much more likely to "crowd out" private investment than it is to boost the economy. If we rush the roads projects, they are much more likely to end up being roads to nowhere and we will end up crowding out good private investment with useless bridges. This plan is contained in the campaign web page (search for infrastructure). I liked the scale of the earlier plan better.

3.) The most sweeping effort to modernize and upgrade school buildings that this country has ever seen. Again, this is a good idea. Public schools across the country are falling apart. New schools need to be built and old schools need to be modernized. This is not a medium-term stimulus plan. Every issue with roads construction is doubled with school construction.

4.) We’ll also renew our information superhighway. I am not even going to comment. Connecting every library in the country to the Internet tomorrow is not going to create enough jobs to ever be noticed. I like the vision: It's not stimulus.

5.) Help modernize our health care system. This was one of the pet projects of the current administration. They failed. In the very long run, making the health care system more efficient is a great idea if it can be done. It will boost the economy and make every American better off -- in the very long run.

I don't think much of the details released so far. I hope the rest of the economic plan has a bit more substance to it. I don't mind spending federal tax dollars if there is at least a hope they might do some good. Spending money for the sake of doing something is a waste of time. And, using the economic crisis to push forward a favorite parts of an existing agenda may do some good (I like the policies) but it won't solve the crisis.