The Recovery and Reinvestment Plan

As regular readers know, I have been both for and against Obama’s stimulus plan. This morning the transition team released details of their economic analysis: the Job Impact of the American Recovery and Reinvestment Plan. We are being sold a bill of goods and I don’t like it.

Let me start my analysis with this quote from Obama’s speech last Thursday.

I don’t believe it’s too late to change course, but it will be if we don’t take dramatic action as soon as possible. If nothing is done, this recession could linger for years. The unemployment rate could reach double digits. Our economy could fall $1 trillion short of its full capacity, which translates into more than $12,000 in lost income for a family of four. We could lose a generation of potential and promise, as more young Americans are forced to forgo dreams of college or the chance to train for the jobs of the future. And our nation could lose the competitive edge that has served as a foundation for our strength and standing in the world. [emphasis is my own]

And from a little farther along in the speech

There is no doubt that the cost of this plan will be considerable. It will certainly add to the budget deficit in the short-term. But equally certain are the consequences of doing too little or nothing at all, for that will lead to an even greater deficit of jobs, incomes, and confidence in our economy. It is true that we cannot depend on government alone to create jobs or long-term growth, but at this particular moment, only government can provide the short-term boost necessary to lift us from a recession this deep and severe. Only government can break the vicious cycles that are crippling our economy – where a lack of spending leads to lost jobs which leads to even less spending; where an inability to lend and borrow stops growth and leads to even less credit.

These are scary words. I am one of those who believe that this recession is going to be bad. I assumed when I read this speech that Obama’s economic agreed with my assessment; in fact, I assumed they had a much gloomier outlook than my own. The release today contains details of the team’s economic analysis.

Take a look at Table 1 on page 5. For the moment, just focus on the first line of the table, labeled without stimulus. According to the analysis, real GDP at the end of 2010 will be $11,770 (annual rate, chained 2000 dollars). From the rhetoric in the paragraph above, I expected their estimate of the decline in GDP to be greater than 10 percent. After all, losing the potential and promise of a generation is a Great-Depression-like event. Instead, Obama’s team is actually expecting GDP to rise 0.5 percent over the next two years (real GDP in 2008:Q3 was $11,712. An annual growth rate of 0.25 percent is very weak: it is not catastrophic.

So first, they want to spend almost $1 trillion dollars to save the economy from slow growth. But there is more. Take a look at the next line; it gives the level of GDP at the end of 2010 with the stimulus. They assume that GDP will reach $12,203 billion. That is, the stimulus will increase GDP by 3.7 percent relative to the non-stimulus baseline.

If they spend $775 billion on the stimulus, they will be spending 5.3 percent of GDP today to boost GDP by 3.7 percent over two years, all to save us from an assumed period of slow growth.

We can do the same analysis with their jobs numbers. According to their analysis the stimulus will save or create 3,674,000 jobs. That is a lot of jobs. I am not quite sure why we are going to lose so many jobs if GDP is going to remain more or less constant, but let’s assume these numbers are correct. At a sticker price of $775 billion, these jobs cost $210,941 dollars each. Median household income in 2007 was $50,233. I am not sure this is a good deal. Which would the median household rather have a job today or $210,941 today followed by a four-year unemployment spell.

We can skip the next several sections—do they really expect us to believe they are so good they can predict who is going to get the jobs—and move to the appendix. The appendix is (allegedly) using estimates of fiscal spending multipliers from FRB/US the Federal Reserve’s economic forecasting model. In the first paragraph, the report says “We considered multipliers for the case where the federal funds rate remains constant.” This assumption seems innocuous. The Fed’s interest rate is at essentially zero and is expected to remain there for a long period of time. But this assumption means that the large increase in government spending has zero effect on the interest rates of any maturity or type. Since no prices move, private consumption and private investment (within the model) cannot react to the government spending. They hardwire into their estimates that the private sector is not crowded out: the only effect of government spending comes through increased income. You don’t have to be a hard-line Ricardian to think that spending a trillion dollars might have some impact on private decisions.

Misusing the multipliers is a serious mistake. The economic team is clearly trying to use the stature of the Federal Reserve to boost the credibility of their estimates. They are either intentionally deceiving us as to the likely effectiveness of their plan or (and much worse) they do not realize the severity of their mistake.

Japan: The Canary in the Coal Mine

"When the canary dies, there is nothing to do but run for the exit" Anonymous

Japan’s economy appears to have fallen off a cliff in the fourth quarter of 2008. The decline in production, exports, shipments, the labor market, … all point to a recession of titanic proportions. Every data series I checked looks at least as bad as it did during Japan’s 1997 recession which took place amidst the Asian Financial Crisis. Most of the series are considerably worse. Flemming Nielsen of Danske Bank does an admirable job of summarizing the recent economic data and its implications for Japan in this note: Japan: Sharpest drop in industrial output ever.

Based on the data received over the past week, Mr. Nielsen expects a fall in fourth quarter output in excess of 5 percent (annual rate). He is most likely right, although I would point out two sources of upside risk to his forecast. First, given the sharp drop in production, imports are likely to fall sharply in December, making an arithmetic positive contribution to GDP. Second, inventory accumulation is large. He points out the large accumulation but seems to miss the potential impact on GDP. This impact could be even further exaggerated if prices fall, boosting real NIPA inventories. Neither of these risks is good for Japan, but they may support GDP.

In any event, Japan’s economy is in big trouble. I am much more concerned, however, with what Japan’s data has to say about the health of the global economy. All of the data releases discussed in Mr. Nielsen’s report are for November: Japan leads the world in the early release of economic data (it’s noisy and subject to revision but early). We have yet to see meaningful macro data in the other industrial countries for November.

The fall in Japanese production was driven by capital goods, intermediate (producer) goods, and motor vehicles. The fall in motor vehicle production, while bad, is not a surprise. We already knew car production was curtailed in the United States and Europe and there is no reason to expect Japanese car makers to escape the decline in auto demand.

The fall in capital and intermediate goods, however, is ominous. The decline in demand, long evident in the consumer sector, has reached the level of production. Capital goods are investment goods and intermediate goods, as the name implies, are necessary for production. Output is falling, is likely to fall much further, and the decline is not isolated in Japan.

Real Japanese exports fell 14.5 percent in November. The drop in exports was spread among Japan’s trading partners, with large falls to the United States, the European Union, and China. While trade data never lines up month for month perfectly, the large drop in Japanese exports implies a large drop in demand across the rest of the world.

The decline in Japanese trade is not anomalous. Since July, the Baltic Dry Index, the best timely indicator of shipping costs, has fallen like a rock. The index, which had soared to astronomical heights over the last several years, is now sitting at about ½ of its long-term average. The most likely candidate for the fall in the price of shipping is a sharp reduction in the volume of global trade.

In addition to the trade data, recent survey data in the United States seem to corroborate the Japanese story. The manufacturing reports for November recently released by the various Federal Reserve banks indicate a sharp fall in activity. Most of these reports have now fallen to record or near-record lows. Taken individually I would be inclined to discount them; but as a group and combined with the Japanese data, they indicate devastation.

Brace yourself. The data flow over the next month or two are likely to reveal a global economy that is significantly weaker than was previously known.

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.

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 individuals—so, 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.