Wednesday, February 25, 2009

Japanese Trade: These are depression-ready numbers

Japanese trade data came out today. The results were stunning. With an almost 16 percent fall in January, Japanese exports have fallen 32 percent in the last three months. This is not an annualized number. Macro data series in industrialized countries (or anywhere else for that matter) simply don’t move like that.

Any optimism I may have had on the global outlook has now fled. Japan exports goods and services primarily to the United States, Europe, and China. Since Japanese exports are foreign imports, this also means that domestic demand in those economies is falling.

The fourth quarter was monumentally bad across the globe. Asia was by far the hardest hit but most economies experienced a decline in GDP and the declines were all bigger (or at least comparable to) their largest declines in the post-war era.

Worse, the deterioration in activity accelerated toward the end of the quarter. The acceleration was most evident in trade and industrial production. Countries as diverse as Brazil, Taiwan, and Germany now have annual falls in IP many times larger than the largest previous downturn on record.

The decline in January Japanese trade means the collapse continued beyond the fourth quarter. That the decline in trade was the biggest monthly fall yet indicates that we have not yet reached terminal velocity. The story is further supported by January capacity utilization for the United States, 68 percent a series low.

To add to this gloom, we have February survey data for the United States and Europe. All of these surveys, after a brief pause in December and January, resumed their downward trajectory. The range of surveys at their record lows

Are we already in a Depression? I said we wouldn’t get close. Then I said, we would probably see one from where we ended up. Now, there is a chance, just a small chance, that we are already there. I don’t know.

Here is why I am worried. There are large portions of output we don’t measure well. And, it seems to me that a lot of the data that has been supporting growth is in these areas. For example, if you look at a close breakout of U.S. trade, goods trade (measured very well) is falling rapidly. Services trade (I don’t even know why we think we can measure this) is holding up very well.

The way forward: Chairman Bernanke testified before Congress this week. Providing the stimulus measures are effective, he expects the economy to turn around in 2009 or at the latest in 2010. You know my views on fiscal stimulus. I believe the policy actions which will be taken across the globe over the next several months are much more likely to push the global economy further into recession than they are to help. (I know I am in the minority.)

There is only one way out of this quagmire and that is forward. It is a painful path: There are no easy answers.

The world’s industrial structure is oriented towards the U.S. (and to a lesser extent the European) consumer. We supported that structure with ever increasing levels of debt. The increase in debt was not supportable. Maybe it would have worked out if productivity growth had stayed in the threes, maybe not.

NorthGG would say we need a large fall in prices to clear these markets. He is right; that would have been an easier path, but it’s not going to happen. Instead, we are going to have to suffer through a long period of adjustment. The adjustment period will last until we have worked off our excesses.

The adjustment won’t be all bad. There will be times when the economy grows well. In the Great Depression 1935 was a pretty good year. In Japan’s lost decade, 1995 and 1996 were pretty good years. I don’t know how long the adjustment will take. Right now I think it is 50/50 between two years and ten. I don’t think there is room for a middle ground.

Tuesday, February 24, 2009

The Fiscal Multiplier: Another Stab at Fiscal Neutrality

Apparently, using Japan as an example for the study of fiscal multipliers carries baggage. There seems to be a thousand reasons why Japan in the 1990s was not a good laboratory for fiscal experiments. I am sympathetic: Fiscal stimulus tends to occur at economic turning points and causality is difficult to determine.

I tried to think examples of large changes in fiscal expenditures that were not intended as stimulus (and where quotas were not imposed). The best example I could think of was the rapid increase in government spending associated with the ramp up in cold-war military spending in the early 1980s.

Of course, 1980 is also convenient because it is home to the largest post-war decline in output in the United States. I think once again the timing of changes in fiscal spending versus the timing in changes of GDP is informative.

Take a look at the picture immediately below. The picture shows real GDP for the United States and real federal expenditures on government consumption and government investment. I have placed a black vertical bar at what I believe is the break point in Federal spending. Both series are indexed to 100 at this point, the fourth quarter of 1979.

Importantly, this spending is not down (at least directly) for economic reasons. All of the 1979 and almost all of the 1980 increase in government spending is defense spending. [As an interesting aside, this ramp up is associated with Reagan. But, Reagan was not elected until November 1980 and did not take office until January 1981: the beginning of the buildup predates him.]
Just as we saw in the Japanese case, GDP did not fall until after the increase in spending. The fall in GDP could not have caused the increase in G. And, G did not cause GDP to stagnate forever, eventually, around the first quarter of 1983, the economy began to grow. Perhaps the economy adjust to the faster growth rate of G or perhaps the relative growth rate of G fell.

In the next picture, I show the same picture on the same scale except that I now scale government expenditures by aggregate GDP. The red line then depicts the ratio G/GDP. In this space, the story is easier to tell. Government spending, particularly defense spending, was decreasing in relative terms from the wind-down following the end of our involvement in Vietnam. In 1979 as our embassy was overrun in Tehran and as Soviet tanks rolled through Afghanistan, defense spending increased sharply and continued to grow relative to the rest of the economy through the end of 1982 where it leveled out. In 1984, defense spending fell and G began once again to grow at the same pace as overall GDP.

I have placed a dashed black vertical line at the leveling off point for government spending. I find it remarkable that the two series, GDP and G, turn in the exact same quarter. Again, G is not responding to the upturn in growth, the turning point is too quick, the timing too tight for fiscal policy.
A multiplier calculated over this interval would either be zero or negative depending on the exact start and end points. That is, government spending increased and private demand decreased by an exact equal and opposite amount. Remember, there were no quotas; this is simply a result of private agents responding to changes in real relative prices. (We will deal with Volcker below.)

I find this example completely convincing. I have a feeling it will not move pro-fiscal policy advocates. What we need to compute the multiplier is the counterfactual: what would private demand have looked like in the absence of fiscal spending. Again, if you simply know the multiplier is 1, then you can compute the path of private demand in the absence of the expansion of government spending.

Fortunately in this case, we do have a counterfactual: our neighbor to the North. Canada is a very similar country in terms of manufacturing structure and customs to the United States. It is not a perfect counterfactual; Canada is rich in commodities and during this period there were large swings in commodity prices. Nonetheless, we press on.

This picture below adds real Canadian GDP also indexed to the fourth quarter of 1979. Before we look at the time between the vertical black bars, look how similarly the growth rates of GDP in the two countries behaves outside of this interval. On this scale, I have trouble seeing any systematic differences.

Now, look at the relative behavior during the ramp up in defense spending in the United States. Canadian GDP continues to grow and grow robustly until the third quarter of 1981. The picture below shows the ration of Canadian to U.S. GDP. The gap between U.S. and Canadian GDP reaches 5.3 percent in the second quarter of 1981. I cannot think of a better counterfactual.

There is one final issue to deal with during this episode. Most economists know that the 1980 recessions were caused by monetary policy: the Volcker Stabilization. In order to bring inflation under control in the early 1980s Volcker cranked real interest rates up to nearly 10 percent. The increase in real interest rates pushed inflation down at the expense of economic growth.

Monetary policy may have caused the increase in interest rates. I believe it was the time path of government spending itself. If we pretend the United States is a closed economy, we can use the intertemporal Euler equation to generate a path of interest rates consistent with GDP and government spending. In particular, 1 = (1+r) β E[U’(Ct+1) / U’(Ct)] and in the closed economy (ignoring investment for simplicity only) Ct = Yt - Gt. In the tradition of macro finance, we can plug in observed values of Y and G and produce a series for r.

The following picture gives the results. I assume utility is CRRA with modest risk aversion. (In a standard utility function σ=1.5, a very low value for macro.) I use the three year forward growth rate of GDP.

Notice how well the model-based interest rate matches the real interest rate, over this time period. In particular, the timing of the large increase in interest rates in late 1979 and early 1980 is nearly identical. The model accounts for more than 60 percent of the Volker tightening. And it does so using only the simplest form of the intertemporal Euler equation.

This result is not consistent with the monetary policy story. In the Volker story, interest rates rise today and GDP falls in the future. What the picture is telling us is that during the Volker Stabilization, GDP was low today and rose in the future.

Monday, February 23, 2009

China: A Gloomy Outlook

I have written several times now on the likely adjustment of consumption in the United States and to a lesser extent Europe. The United States has supported its unsustainable consumption growth through ever increasing imports. And, China has been a willing provided of both the goods and the financing. As a result, China has experienced an era of amazingly high economic growth.

This era has come to an abrupt halt. Or, more accurately, this era came to an abrupt halt in the summer of 2008.

There are many indicators of Chinese malaise. The picture below, however, is all I need to tell me China is in big trouble. Since 2000, China has emerged as an export-import economy. China imports primarily commodities and unfinished goods, adds value through processing, and then exports the finished goods abroad.

Nominal exports have fallen 18 percent over the last twelve months, incorporating about a 10 percent decline in prices and 7.5 percent in volume. The fall in nominal exports is a decline in income for China. The fall in volume shows the decline in units processed. Nominal imports have fallen 43 percent. The bulk of this decline reflects a decline in prices but 12.5 percent is a decline in volume.

The fall in exports reflects the global fall in demand. This is bad for the Chinese economy but is not unexpected. Whatever happens in China, we expect their external demand to fall. To me, the fall in imports is far more important as an overall indicator of the health of the Chinese economy.

As an axiom in economics, if a fall in price corresponds with an increase in volume, it’s a supply shock. If a fall in price corresponds with a decrease in volume, it’s a demand shock. China’s demand has fallen. And, since China’s imports are almost all intermediate inputs, this means manufacturing output in China is falling. No country, let alone a country with complete reliance on the external sector, could withstand such a large fall in exports. (Can anybody find a country that experienced such a large decline without a contraction? Email me at secreteconomist ‘at’

So far, domestic Chinese statistics have held up better than the picture implied by exports and imports. Both IP and GDP have slowed, but do not indicate contraction. Taking a stab at converting the year-on-year growth into quarterly changes, both series grew in the low single digits at the end of the year. Retail sales growth continues apace.

There may be a timing issue. The contribution from net exports may be sufficient to offset the decline in production; however, this cannot last. Alternatively, there may be forthcoming revisions to the GDP and IP data that will give a clearer picture of the economy. (I am not saying they are miss-stating their statistics. National income accounting is hard and many countries, including the United States, have large revisions to the data.)

In any event going forward, the Chinese economy will follow the path of its neighbors. I know that I am in the minority. Every China analyst seems bullish on China. They see signs of an imminent recovery around every corner. They are wrong. China will contract and cannot recover while the rest of the world remains in freefall.

China may, in the long run, reorient its economy and grow without external demand, but we are a long way from the long run.

Fiscal Stimulus: Does the Multiplier Really Have to be 1?

The “stimulus” plan has now passed. So, this discussion is purely academic. We shall see what if any effect the legislation has. But, I heard over and over again during the debate that “of course, the multiplier on government spending must be at least one”. This statement is based on a false assumption.

A multiplier of one means that an increase in government spending increases output dollar for dollar. That is, the government can increase its spending without any change in consumption, investment, or net exports. Take a look through the lens of the national income identity:

Y = C + I + G + Ex - Im

Y is output, C is private consumption, I is private investment, G is government consumption and investment, Ex is exports, and Im is imports. A multiplier of one means an increase in G leads to an equal increase in Y. That is,

↑Y = C + I + ↑G + Ex – Im.

Taking the identity seriously, how exactly did G increase? G is real government consumption and investment; it does not include transfer payments. If the government increased G, it must have increased its purchases of inputs: labor, capital, and materials. Where did the government purchase these resources? The answer to this question determines the amount of stimulus embedded in government spending.

The idea behind stimulative Keynesian government spending is that there are idle resources during recessions and the government (following a different objective function than the private sector) is best positioned to use these resources. I actually have no problem with the underlying thought experiment: high unemployment and rising inventories certainly implies underutilized resources. And, the government certainly has the capability of quickly hiring workers and purchasing inventories.

However, while these resources may have been idle, they likely still had positive prices. If they had positive prices before the government spending program, then the increase in demand from the increase in government expenditures must have pushed the price up: the government had to outbid the current holder of the resource. This rise in price, no matter how small, reduces private-sector demand.

It is easiest to think of the government hiring labor from the pool of unemployed workers. The existence of unemployment (let’s leave aside temporary frictions) implies that at current wages firms are unwilling to hire all available workers. Equivalently, at current wages workers, in aggregate, are unwilling to supply more labor. If the government steps in with a jobs program, wages increase. [Take this as an axiom, where the wage is actually the shadow price of labor. I don’t want to get into a discussion on LaGrange multipliers.] With higher wages, some marginal firm in the economy will reduce its demand for labor. This reduction private-sector employment prevents the multiplier from being automatically one: the increase in government spending resulted in a decrease in private employment. We can do the same thought experiment for any other input.

Of course, the multiplier could still be one; I have only shown that it is not automatic or obvious. The bar for large multipliers is quite high. For the multiplier to be one or higher, the government spending must increase output itself and somehow spur either private investment or private consumption. In the spirit of Keynes, the government spending must reignite otherwise dampened Animal Spirits.

The question is then an empirical question. Last month, Robert Barro examined the case of the United States during WWII. He found a multiplier on government spending of 0.8. Krugman inaptly points out that WWII does not count because of the consumption quotas. To me the existence of the quotas are the proof of Barro’s point.

Why did the government need quotas during the war? Apparently, the government believed that its acquisition of private resources would drive up prices. For either budgetary or social reasons, the government found these price increases unpalatable and instead imposed quotas. With the quotas in place, they effectively created a supply of goods with zero price (this is where we need the LaGrange multipliers). By my grandmother’s account, these quotas were binding. At existing prices, people wanted to consume more. In the absence of the quotas, the government would have had to consume less.

But, WWII is Barro’s example. For me, I like Japan’s experience in the 1990s.

The Case of Japan: In the early 1990s, asset prices in Japan collapsed. Most famously the collapse was in equity prices but bond prices also fell sharply as companies stopped making payments. In many ways, that crisis is similar to that faced today. In particular, the government was forward looking and wanted to implement the stimulus early, to get ahead of the curve.

The following picture shows private demand, government demand, and in light bars four-quarter GDP growth for Japan between 1989 and 2001.
In 1991, Japan enacted a substantial stimulus plan. By the time the plan ended in 1994, the stimulus amounted to about 3.5 percent of Japanese GDP. The first thing to notice is that neither in terms of private demand nor in terms of GDP growth was Japan’s economy faltering at the time the stimulus was put in place. In the first quarter of the stimulus, marked by the first vertical line, four-quarter GDP growth remained above four percent. Private demand growth was robust.

Therefore, while the government may have simply been forecasting the drop in GDP two full years later, it does not seem we can make the case that the economy was contemporaneously weak. What is striking is that in the same quarter in which government spending began to increase, private demand stagnated.

The government could not have been reacting to fall in private demand for two reasons: First, government spending takes a long time to implement. No government in the world is that fast. Second, and much more importantly, the government did not know at the time. Demand data is released with a considerable lag. We do not learn current quarter GDP growth until about 6 weeks after the end of a quarter.

Further, private demand growth was positive both before and after the stimulus. (The second bump in 1996 is the government’s spending response to a surge in revenue and is not an announced stimulus.) Taking the data series as given, I find a multiplier on government spending of 0.38, positive but well below one. I will go one step farther. If I take as the counterfactual rising private demand, as opposed to flat in the first experiment. If for example, I use the slowest annual growth rate of private demand two years on either side of the stimulus, the multiplier becomes a large negative number.

Of course, many economists believe that government spending in this period is all that kept Japan going. They take private demand as given and calculate the path of GDP that would have occurred had the government spending not been in place. Some go farther, comfortable in their knowledge that the multiplier is greater than one, they compute quite abysmal paths for GDP in the absence of government spending.

We do not have the counterfactual. I cannot directly falsify their statements. The picture above is just a picture. In the end, the debate comes down to one of philosophy. And, as with every adherent to his chosen philosophy, I believe my views are the correct.

Government spending crowds out private demand.

Saturday, February 21, 2009

Krugman’s Excellent Column: Who’ll Stop the Pain

As regular readers of this blog know, I often disagree with Krugman. He believes a raft of things about fiscal and monetary policy that I simply don’t. I still think he is one of the best economists of our century and yesterday he proved once again that he understands the world quite well, maybe better than anybody else.

Take a look at this column. You have to read the column yourself to get the full force of his ideas. Basically, he manages in a little over 800 words to summarize both the depth of the current downturn and the seeds of the eventual recovery. Spoiler Alert: It’s not fiscal policy.

Go read the column. Then come back and read my thoughts below.

Since, I trust, you have already read his column, I am going to take Krugman’s points somewhat out of order and rearranged. All of the words belong to him.

To appreciate the problem, you need to know that this isn’t your father’s recession. It’s your grandfather’s, or maybe even (as I’ll explain) your great-great-grandfather’s. Your father’s recession was something like the severe downturn of 1981-1982. Your grandfather’s recession, on the other hand, was something like the Great Depression, which happened in spite of the Fed’s efforts, not because of them. The closest 19th-century parallel [your great-grandfather’s recession] I can find to the current slump is the recession that followed the Panic of 1873. That recession did eventually end without any government intervention, but it lasted more than five years, and another prolonged recession followed just three years later.
This certainly puts the current downturn into perspective. Like me, Krugman believes that the current recession is much worse than 1980 but not nearly as bad as the Great Depression. He picks the recession of 1873 as the appropriate historical comparison.

I am a fan of macro data but I don’t quite have a good feel for 19th century data. So, I went to the NBER and pulled their Index of American Business Activity (you can find it here). In my mind, this series is an excellent proxy for industrial production. The series is monthly and runs from 1855 through 1970 and, over the years where it overlaps with the Fed’s industrial production series, the correlation in the 12-month growth rate of the two series is 0.97.

Plotting the whole series is too noisy. Instead, I plot the cumulative loss in output during every major downturn between 1855 and January 2009. I define a major downturn as any period in which the 12-month growth rate of IP is negative for a sustained period. Cumulative output loss is defined as the trough (the lowest point locally in the series) over the highest level achieved in the previous two years.

The 19th century was not a fun time. There were 15 major downturns between 1855 and 1900 compared with only 8 between 1955 and 2000. On average, in the last half of the 19th century a major decline in output occurred once every three years: when did they find time to grow! Output fell an average of 17 percent in each of these episodes. This is half the output decline experienced in the last half of the 20th century.

There are many reasons for the higher volatility in the 19th century. First, the data is likely not as accurate as in the later period. Although, the long term averages should eliminate a lot of the noise in the data. Second, the economy was much more agriculturally oriented. Agriculture by its nature is more volatile and this volatility would automatically feed into industrial output. Third, the Civil War was a rather major event and may have had a large influence. Finally, the late 19th century was a time of rapid expansion, particularly of geographic expansion. The fits and starts of settling the West may also have had a large influence on the timing and size of downturns. Nonetheless, the mere fact that we are now comparing the current downturn to data from the 19th century is scary.

Returning to Krugman’s editorial, I plot just the four recessions he discusses: 1874, 1930, 1980, and 2009. The Great Depression occurred on an unimaginable scale, simply shocking. I think what surprises most people (as opposed to people reading economics blogs on the internet) is that the current decline in production is already much larger than the declines in the 1980 and 1982 recessions. The cumulative decline in output through January is 13 percent.

Thirteen percent is a large fall but I now believe the odds are exactly even on a cumulative fall in output in this downturn exceeding 20 percent. (Note: In production terms, this meets my definition of depression. However, this does not mean the economy as a whole would meet the definition. So far the overall decline has been moderated by a fall in imports and a relatively stable services sector.)

After thoroughly depressing us, Krugman offers us a glimmer of hope. He points out that the rate of adjustment is indeed sufficient to bring us (eventually) out of the recession. Economies tend to recover (not always – think of the middle ages – but they tend to) and ours is likely to recover as well.

What, then, will actually end the slump? The seeds of eventual recovery are already being planted. Consider housing starts, which have fallen to their lowest level in 50 years. That’s bad news for the near term. It means that spending on construction will fall even more. But it also means that the supply of houses is lagging behind population growth, which will eventually prompt a housing revival. Or consider the plunge in auto sales. Again, that’s bad news for the near term. But at current sales rates, as the finance blog Calculated Risk points out, it would take about 27 years to replace the existing stock of vehicles. Most cars will be junked long before that, either because they’ve worn out or because they’ve become obsolete, so we’re building up a pent-up demand for cars. The same story can be told for durable goods and assets throughout the economy: given time, the current slump will end itself, the way slumps did in the 19th century. But recovery may be a long time coming.
The 2001 recession was characterized by a capital overhang. The capital stock, particularly in things like fiber optics networks, was too high. Investment fell and eventually the stock fell sufficiently that investment recovered, although the recovery was tepid and investment growth never returned to its late 1990s levels. This adjustment was aided by the very high depreciation rate on high-tech capital goods.

This recession, in my mind, is characterized by an overhang of durable consumption goods. There are too many houses, cars, and flat-screen TVs. Just as investment fell in 2001, consumption has to fall to work off this overhang (see my thoughts on consumption here). The fall in building and motor vehicle production are part of this adjustment. We are closer to the bottom now than we were before the last month’s worth of data. Overhangs take a long time to work out.

We are still a long way from the bottom and once we get there, if I am right about the path of consumption going forward, the recovery will be more likely slow and gradual rather than the sharp growth acceleration one typically sees in recoveries.

Who’ll stop the pain? We will. The pain will end when we have worked off our excess durable consumption goods and repaired our balance sheets. Then we will move forward a bit more chastened a bit more cautious and a bit less ready to finance our consumption.

Thursday, February 19, 2009

Homeowner Affordability and Stability Plan: Finding a way forward.

I like the idea behind this plan. (You can find the fact sheet here) The Administration clearly wants to help homeowners and is taking steps to do so. The plan is creeping closer to the foreclosure mitigation plan I put forward in this post. I think the plan is net positive for the housing market and that it will help, on the margin. However, the initiative does not solve the fundamental problem that is leading to foreclosure: A large (and growing) number of homeowners are underwater. That is, the amount owed on the mortgage exceeds the market value of the house net of transaction costs.

Underwater households are by far the most at risk of foreclosure. They are at risk for two main reasons. 1. At some point as the value of the home falls, the homeowner is better off defaulting on the mortgage than continuing to make payments. Households in this category are clearly at risk for imminent default. 2. Underwater households are very sensitive to income shocks. If they lose their income for any reason (health, layoffs, wealth losses), they have to default. Had they not been underwater they would have had the preferable option of selling the house. (Preferable because they lose the house either way and with the sale they may recoup some losses and avoid a default judgment.)

Rewriting mortgages such that the payment is affordable (under the household’s current income) solves neither of these problems. A household that cannot afford their current house should be encouraged to move to a house they can afford. It’s not pleasant, it’s not popular, but it is still true. And, there are very few cases where a 1 or 2 percentage point change in the mortgage interest rate will make a true difference between foreclosure and affordability. (Think of the success rate of mortgage modification to date. See my comment here.)

Here is my comment on the plan point-by-point. (Actually, I just comment on the parts that strike me as particularly good or particularly bad.):

Neighborhoods are struggling, as each foreclosed home reduces nearby property values by as much as 9 percent.

I would really like to know the source for this statement. I believe foreclosed properties have a negative impact on house prices. However, empirical studies have difficulty identifying such large effects. Take a look at this recent study by Calomiris, Longhofer, and Miles. This paper is carefully done and is representative of the literature. They find a statistically significant but small independent effect of foreclosure.

Enabling Up to 4 to 5 Million Responsible Homeowners to Refinance

I have no problem with this provision. The Administration wants to allow homeowners who already hold loans guaranteed by Fannie and Freddie to refinance at today’s rates. They are willing to relax the 80 percent down payment rule to make this happen. The only cost to this program is a potential reduction (and a possible increase) in the profitability to the two GSEs. On paper, the institutions are taking on more risk because they now hold low down payment mortgages, but in reality the risk was already there.

This aspect of the plan should have a modest positive effect. Essentially, we are transferring $2300 (the Admin’s number) from Fannie and Freddie to each of the 4 million homeowners. For the absolutely most marginal borrower, this might make the difference between foreclosure and ongoing payments.
A Shared Effort to Reduce Monthly Payments: … the lender [is] responsible for bringing down interest rates so that the borrower’s monthly mortgage payment is
no more than 38 percent of his or her income. Next, the initiative would match further reductions in interest payments dollar-for-dollar with the lender to
bring that ratio down to 31 percent.

Again, reducing payments does not necessarily lead to a reduction in foreclosures. Plus, I suspect, without having the data in hand, that most foreclosed households have had a bigger shock to their income than can be accommodated by an adjustment in interest. Unemployment insurance is not going to cover a very big mortgage payment.

Lenders will also be able to bring down monthly payments by reducing the
principal owed on the mortgage, with Treasury sharing in the costs.

Here is the one sentence in a 2300 word document on principal reduction. The details of the implementation are critical here. Reducing principal is nothing if it is only done to help make payments affordable. Reducing principal is only effective if it moves households back above water. Again see my comment here.

"Pay for Success” Incentives to Servicers: Servicers will receive an up-front fee of $1,000 for each eligible modification … They will also receive “pay for success” fees … of up to $1,000 each year for three years.
The payment reduction part of the plan is intended to serve 4 million households. $4,000 times 4 million households is $16 billion or 21 percent of the $75 billion allocated.

Incentives to Help Borrowers Stay Current: To provide an extra incentive for borrowers to keep paying on time, the initiative will provide a monthly balance reduction payment that goes straight towards reducing the principal balance of the mortgage loan. As long as a borrower stays current on his or her loan, he or she can get up to $1,000 each year for five years.
This is just a transfer and a poorly designed transfer at that. I plan to pay my mortgage (unless my house value falls a lot). I would be glad to get $5000 for doing what I do now. But keep up with the math. This is an additional $20 billion, we are up to 48 percent of the total allocated money in just these two “throw away” lines.

Home Price Decline Reserve Payments: ... The insurance fund – to be created by the Treasury Department at a size of up to $10 billion – will be designed to discourage Lenders from opting to foreclose on mortgages that could be viable now out of fear that home prices will fall even further later on. Holders of mortgages modified under the program would be provided with an additional insurance payment on each modified loan, linked to declines in the home price index.
$10 billion dollars is not even in the right ball park to actually insure these loans.
Supporting Low Mortgage Rates By Strengthening Confidence in Fannie Mae and
Freddie Mac
Here I will simply note that the Administration is spending more than 3 times its total homeowner initiative to work a backdoor support of the housing market.

So, in the end, although I think the plan has many positive aspects. It will not help the mortgage market much.

Wednesday, February 11, 2009

The Financial Stability Plan: A Recipe for Failure

This plan, as with TARP before it, is fundamentally flawed. From the takeover of Fannie and Freddie, to the bailout of AIG, the government has treated this crisis as one of liquidity. With a liquidity crisis all the government needs to do is essentially backstop the financial institutions. With the backstop in place, the liquidity crisis ends and the financial sector returns to normal and eventually the economy recovers.

If the crisis is not a liquidity crisis, if instead the crisis is one of fundamental solvency, government intervention does not necessarily resolve the issue. Indeed governments around the world have a poor track record of resolving solvency issues. According to a recent study by Ela Glowicka, only 40% of European companies receiving government bailouts survive 10 years. This is not the first study to come to such a conclusion.

I wonder how many of those bailouts began because the company claimed a temporary shortfall of liquidity.

What would it take for the Financial Stability Plan to be effective? The federal government has large resources available to it. These resources could be used to bailout the financial system. A sufficiently large transfer of resources from the government to the banks would ensure their viability. But these resources cannot be transferred in a manner that protects “taxpayer equity”.

If a firm is insolvent, the value of its liabilities exceeds the value of its assets. For the firm to become solvent, it must receive a transfer equal to the shortfall. Since all firms and especially financial companies need capital to operate, the transfer must be even larger: the transfer must be sufficiently large that the firm is a viable ongoing concern.

Bailing out all of the financial companies is likely not feasible. Therefore, if the government wants to make the public policy decision to bailout the financial sector, it must first decide which companies should continue and which firms should fail. There is no clear cut criterion by which to choose: nobody said public policy was easy (that’s why I do economics).

Treasury Remains on a Bad Path. Despite its size (I am still reeling over the $2 trillion initial price tag), the Financial Stability Plan does not actually bailout the banks. Rather, the plan provides only enough capital at any one time to keep the firms solvent. The plan is designed to continuously increase the government’s position in the banks as the economic situation worsens or as the banks experience greater-than-expected losses. No firm can survive waiting hand-to-mouth for the next check to arrive.

Japan’s Banking Intervention in the 1990s Should Serve as a Warning: The Japanese government’s intervention in its financial sector is an excellent example of how not to bailout the financial sector. Also as a result of over-leverage on the part of firms, households, and financial companies, Japan’s banks developed a non-performing loan problem (NPL) in early 1990s—in the current jargon, they had toxic assets on their balance sheets.

As a result, credit slowed, banks balance sheets were under pressure, and inter-bank lending became more difficult. The Japanese government also used its “full arsenal of financial tools” to deal with the problem. It guaranteed deposits, it injected capital, and assured investors that it would not let the banks fail.

None of these efforts were successful. Japanese banks did not fail, but they also were unable to operate as efficient financial intermediaries. It was not until late 2001 and early 2002 that the Japanese government finally forced the banks to remove the NPLs from their balance sheet, injecting enough capital to get the banks lending. I do not know the total size of the intervention but it was substantial. Only after this all out solution, did the Japanese economy begin to grow once again like a “normal” industrial economy.

The United States has a Bigger Problem: One of the main reasons for the current crisis is over leverage. Households borrowed too much and so did banks. Neither the households nor the banks can afford their balance sheets. Both must work to correct the excesses.

Unfortunately for financial sector, the work out in the household sector means that the financial intermediation sector needs to shrink. In principle, this adjustment could occur with every financial company simply getting smaller. That is not the way adjustment tends to happen. Typically, in these downturns, some firms must disappear. If the markets are left to their own devices, the strongest best managed (likely most risk averse) firms will survive. If the government decides, the adjustment is much more likely to be simply random.

Friday, February 6, 2009

The Jobs Report was Worse than You Think

The jobs situation is bad. Whether you look at the payroll losses or the household survey, the decline in jobs is greater now than at any time since before WWII. In the household survey, the number of jobs lost over the last twelve months is double the loss at any time in its history. That’s right, double. The payroll survey is not quite that bad and is simply flirting with the worst of its post-war losses. Either way, the job losses are making 1982 or 1974 look like mild down-shifts in activity. Note as well, that the level of jobs in December was revised down by 333,000.
Also, this month’s report made it clear to me that the household survey is currently giving a much better picture of the employment situation than is the establishment survey. Usually, the establishment survey gives a better read on the monthly variation in employment; the structure of the survey gives less month-to-month volatility.

Over the past year, the household survey has behaved quite consistently. This tells me that the monthly changes in the sample are not moving the overall jobs numbers. This stability tells me that the deterioration in the jobs situation is widespread: any random sample gives the same picture.

In the fourth quarter, every major macro series took a nose dive. From housing to orders to industrial production, from exports to imports, to private consumption, to car sales, every series was falling at or above record rates. Yet somehow magically, the establishment survey stabilized. Yes, 500,000+ in monthly job losses are bad, but they did not continue to deteriorate over the quarter. The household survey took exactly the path I would have expected given the other indicators. And, the household survey is coming in (month after month) closer to my jobs model. I believe there will be major downward revisions to the establishment survey in the months to come.

What is your over/under for GDP in the first quarter?