Economics

Funny thing economics. One person’s bad news is another person’s good news. this morning’s housing start data is a good example. First here’s the data as reported on MarketWatch.com:
Housing starts plunge to another record low – MarketWatch

The market reacted very negatively to this news as if it is bad. Perhaps this morning’s dive in the Dow was more influenced by the poor job loss data and the news from Microsoft that it was laying off 5,000 workers, but somewhere in there the housing data added to the gloom. Both starts and the issuance of permits [and therefore an indicator of future starts] fell to record low levels. As a sign of the general confidence level in the economy these are very bad numbers. Clearly the construction business is going to take a long time to recover, and we should recall that construction was one of the very few bright spots for employment throughout the Bush years.

But wait.

We have a huge backlog of unsold homes. At the current rate of sales that backlog is almost eleven months. So the dramatic slowing down of starts will surely help, not hinder. The backlog will not be increased by a steady flow of newly constructed homes coming on the market later this year. Instead, as homes are sold, albeit at slow rates, they will diminish the inventory of unsold homes rather than be replaced. This means that even at our current low rate of sales there seems to be a floor developing under the inventory of unsold homes. That helps limit the likelihood of further declines in home prices. In turn that abates the erosion of equity and assists the whole recovery in housing. It was real estate that got us into this mess. Maybe this is the first sign that the rot is ending. The ripple will be felt in banking too: the credit crisis is an outcome of those horrible mortgage backed securities [‘MBS’] that no one knows how to value. If we start to get our feet under us in terms of home prices, then those MBS packages that look so toxic today will be easier to value, and bank balance sheets will start to recover too.

So why did the market not see the good news hidden in these awful housing start statistics? Because it thinks and acts like a short term herd. Sometimes it pays to stop and think a little more.

These terrible figures for home starts are actually very good news.

You heard it here first.

Here’s more links on my favorite topic … Should Obama Seize Citigroup? – The Opinionator Blog – NYTimes.com

The terms of the debate are shifting. The system is unstable without forceful and direct action. The current shareholder and management combinations of our major banks have proven to be a disaster. Get rid of them and wipe the slate clean.

The point is this: how can we trust the managements, the analysts, the advisors, and the academics who brought us the current toxic mess?

Who among them has earned the right to take taxpayer money without forfeiting control?

Just as much as the banks cannot identify which of their assets are worth anything, we cannot tell which of these management teams is worth anything.

It will take too long to figure that out. So let’s get on with putting in place a solution.

I think it safe to say that those who argue against nationalization are those who endorsed the policies, procedures, and management techniques that led us to where we are. If the market was so efficacious then money would be coming forward to capitalize the banks. It isn’t. The market is broken. Time is a-wasting.

Nationalize.

Now.

Here’s an excellent article in today’s New York Times by David Leohardt about the comparison between our current economic mess and the infamous 1981/82 downturn: Economic Scene – The Economy Is Bad, but 1982 Was Worse I recommend it because we need to keep perspective as we throw around words to describe the current problems.

Statistically some of the measures we use to describe an economy were much worse back in 1981/82 than they are now. For instance, Leonhardt has done some useful legwork to show the comparisons between the two periods in terms of employment. In raw terms that recession appears to be worse than this one, at least so far.

What I think needs more highlighting is the dramatic nature of the intervening period.

The entire Reagan era comes between the 1981/82 downturn and today. Ronald Reagan was elected in part because of the gloom that rapidly pervaded after the second oil shock of 1979. Jimmy Carter fumbled the response to Iran and then tried to be sober about the real world implications of an oil based economy like that of the US when faced with fanatic regimes such as the one that had taken over in Iran. The election that brought Reagan to power was very much a choice between the earnest but gloomy advice of Carter against the perky and patriotic flag waving of Ronald Reagan. Naturally the optimistic view won.

The problem is that the Reagan vision was an illusion. His series of right wing epithets about government being the problem and so on allowed the public to avoid confrontation with the deeper movements going on in the world economy. Carter had been right: America needed to restructure itself to be less dependent on oil. It had to recognize that the era of poor worldwide competition was over. Instead the public was sold a free market doctrine as a gloss over these underlying problems. The right wingers thought that freeing markets would naturally allow America to overcome its problems. Under locally constrained circumstances they are correct. What they forgot is that capitalism is an engine of wealth generation that is global, not just local. It seeks to go where the most wealth can be made. That is not simply here. Other people make stuff too. Plus some of them have the oil.

Both the optimism and the right wing ideology was built on a false premise: that the American per-eminence of the 1950′ and 1960’s was a result of some inherent American economic genius that had to be re-energized and set free from government control. The idea was that this freeing would then return America to the fast paced growth of the post war decades and all would be well with the world once more. In other words: the 1970’s were an aberration caused at least in part by the enlargement of government safety nets and regulation that stifled America’s innate economic prowess. As if no one else could harness a capitalist engine of their own.

I remember arguing against this view at business school back in 1978 and 1979. It was wrong then and has been proven to be wrong since.

Why is this relevant to Leonhardt’s article?

For the same reason that today’s recession feels worse than the 1981/82 downturn.

There are deep global shifts going on that inhibit the extent of upturn on the other side of this recession. The gloss of the dot.com bubble and the real estate bubbles hid the shift going on in the world economic order. The entire Reagan era was built upon sand. The wealth of the Reagan, Clinton and Bush years has been shown to be largely false. The foundation was an unsustainable run up in asset values, but the returns on those assets never kept up enough to sustain the respective bubbles. Further: foreigners learned how to compete. American products became obsolete in many crucial fields, notably automobiles. Foreign workers were willing to work for less than the wages Americans paid themselves for doing the exact same work. Yet adjustments were not being made deliberately to guide America painlessly into the new world because the free market ideology that pervaded Washington, in both parties, prevented intervention or spending on re-training.

So even as wealth seemed to pile up in the 1990’s and 2000’s the tell tale signs of rot were there: in particular wages flattened out. Inflating home prices became the average Americans best access to the American dream. Not rising wages, but asset inflation. Yes that’s right: our best source of funding to support consumption growth was inflation. Second mortgages released cash from those home values so the consumption binge that has characterized the American economy for 60 years could continue. But the binge was now paid for by writing ever larger IOU’s, not through higher productivity which is the sustainable source of wealth.

This does not mean American workers didn’t escalate productivity. They did. Except that increase in productivity went to profits, not wages, and to maintaining competitive advantage in the face of foreign competition.

American workers were running in place, but felt as if they were advancing.

So when the wheels came off and reality was revealed the gloom descended more rapidly than the statistics Leonhardt discusses indicate should have happened. The public suddenly woke up to face the shocking thought that the entire Reagan era was an illusion and that hard choices had been avoided along the way. The binge was over. The recovery will have to be old fashioned: long, hard, and built on concrete.

That’s nothing to be frightened of, but it is a shock. Hence the sometimes hyperbolic reaction to the current economic mess.

So the short response to Leonhardt: we are going through an unusual confluence of a downcycle [1981/82 was such a downcycle] and a structural adjustment such as we haven’t seen for almost a century. The short cycle and the long cycle are occurring at the same time.

Bummer.

Well, the dramatic fall in bank stock prices is pushing us closer to the day of reckoning when American policy makers will have to face the prospect of full nationalization of at least one, if not two or three, of our largest banks. I have been beating this drum for a while and want to keep the pressure up because I believe strongly that nationalization is the quickest, cleanest, and ultimately cheapest way to get the credit markets cured and working again. Here’s yet another link of resources for you to read through. Once again my source is Paul Krugman and thence the Financial Times: Financial Times: Nationalisation linkfest

Some of you appear taken aback by the very word ‘nationalization’ as if it portends the end of the universe, or at least the end of the good old US of A. There seems to be something almost dirty and certainly ‘unAmerican’ about nationalization as if only those failed Old Europeans do that neo-socialist stuff. Us healthy young Americans don’t resort to socialism.

Nonsense. And poppycock.

First: the nationalization would only be temporary. It would be for a two or three years, or as long as it takes to knock some sense into the banking system.

Second: many of our major banks are already ‘technically’ insolvent on a market value basis, and are only avoiding actual bankruptcy by hiding behind the increasingly thin veil of historic cost accounting. That’s like arguing a corpse is still alive because it had a heartbeat yesterday. History means nothing in finance. The relevant question is what could you sell those assets for today. If the answer is ‘not much’ or ‘less than my liabilities are worth’ then you’re bankrupt whether yesterday’s asset values were golden or not. One of the major issues in the credit markets at the moment is that all those toxic real estate assets are still tough to value. No one knows what they’re worth. And if they still represent a large chunk of a bank’s balance sheet, as they do in several cases, then we also don’t know what the bank is worth. Toxic assets are an anathema to banking because it undermines the inter-bank market: banks can’t lend to each other when there is no confidence in asset values … where is the cash coming from to repay the loan? People beholden to shareholders don’t take those risks. They protect themselves. Countries with printing presses to manufacture money don’t have to worry so much about the niceties of interbank credit. Hence the attraction of nationalization: it frees banks up to lend again.

Third: following on from this is the criticism leveled by Willem Buiter, whose comment is buried in the list of links I have given you above. He points out that giving banks cash in the form of only partial ownership is actually creating an incentive for them not to lend. This is because the banks are given an incentive to hoard cash in order to pay back the government at the earliest moment. So instead of using the capital injection to recommence lending, the banks, perversely from a policy perspective, stop lending and hang on to the liquidity in order to get the government out of their hair more quickly. The capital injection, if it brings only partial ownership, halts lending rather than encourages it!

Fourth: asking private banks to get on with lending right in the middle of an economic downturn is also perverse. There is a high probability that loans made now have an above average default rate because of the weak cash flows and poor economic prospects that borrowers have during recessions. So lending now would create more credit losses down the road. Naturally banks want to avoid that, so they shut down or minimize lending until there are signs of an economic recovery. Nationalization relieves this problem because the government is less worried about future loan losses and is more focused on getting the recovery going by making credit available. Again: governments can print whatever money they need to replace any losses that may emerge.

In normal business cycles the government is able to fire up the credit availability simply by lowering interest rates. When money costs less to borrow even risky projects can make money [the cost of capital is the key component in measuring the return on a project], and so businesses can find lenders willing to make loans.

But this is not a normal business cycle. Interest rates are so low that they cannot be lowered sufficiently any more to loosen the credit market. this is the cost we are paying for the mismanagement of the Federal Reserve Board throughout the last ten years. Interest rates were kept artificially low for years even while the real estate bubble was emerging. Asset price inflation was completely ignored and we were told that the market would take care of itself.

Well it did.

And it’s taking us down too.

So without any normal levers to pull to get the credit markets running again, and with an unprecedented asset bubble undermining asset and bank balance sheet values, we are faced with an unholy mess. The only credible solution is direct intervention.

Nationalization of a few large banks, say Bank of America and Citibank, would instantly relieve pressure in the interbank markets; it would free those balance sheets from the straight jacket of recovery and put them to use as sources of credit. Once the economy recovers the assets that currently have an uncertain value [and are therefore inhibiting credit growth] could be sold off since their values will be more reliable in a the, then, more stable conditions. The resulting cleaned up banks can then be auctioned off back into the hands of private shareholders.

Why is this so difficult to grasp?

The deal between Chrysler and Fiat announced today is truly remarkable for one thing: no cash changed hands. Here’s the news from MarketWatch.com:
Fiat gets 35% stake in Chrysler for no cash

Isn’t this odd?

Here we have Chrysler a cash strapped and near bankrupt company making a significant business deal in which its owners dilute their ownership and get no cash in return. Not just that, but Fiat has made no commitments for future funding either.

This is the kind of deal that is struck all the time. One company gives access to technology or another resource in return for wider distribution of its products through another company’s marketing channels. That is not extraordinary at all. It is part of the normal strategic give and take in big business.

What is strange is that Chrysler entered into this deal and received no capital injection. This is all while cash is Chrysler’s most urgent issue.

Is their situation so dire that there are no cash partners to be had? Or is it simply that they think they can cobble together a survival strategy with stunts like this and thus justify more government funding.

The Chrysler CEO’s comments seem to indicate that the taxpayer is the audience he needs to address most clearly. Rightly so. But does this deal assure us that Chrysler has a restructuring plan worth the government investing in? I don’t think it does. The benefits of this Fiat arrangement are going to be in a year or two not now, and who knows whether Chrysler will last that long?

All the US automakers are trying to ‘restructure’. What they need to do is radically shrink their operations to suit their reduced market shares. They need to cut costs to staunch the outflow of cash and find ways of acquiring capital to help them fund their transitions. Turning a company like Chrysler around takes a while during which it will continue to lose money. So the first priority, I would have thought, would be to get an infusion of cash.

This deal doesn’t do that. Which means that Chrysler has declared itself to be at the mercy of the government.

Let’s hope those restructuring plans are good enough to convince the government. The cash doesn’t seem to be coming from anywhere else.