interest rates

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The New News Is Old News

Nothing changes it seems. Our rocky economy remains rocky. Instead of moving steadily towards the higher ground we are, apparently, doomed to wander in the lower reaches of recovery. This is not good news since it exposes us to a higher risk of relapse. But what’s new in that comment. Nothing.

Today’s report on new claims for unemployment assistance is just one more signal that we are stuck. By now we should have been well below the levels of late last year. Indeed the first months of 2010 showed significant improvement. Yet here we are back at 500,00o new claims a week, up 12,000 from last week, and back where we were last November. The pundits all seem shocked. I am simply disappointed. This sticky job market is fast becoming the touchstone issue of the entire cycle. Our economy appears unable to generate sufficient jobs, even though we have now experienced several quarters of growth.

My perspective, as you all know, is a little different from the breathless types who populate the media. I never expected a robust recovery – history teaches us not to expect such a thing after a financial crisis – and the stimulus was way too small to kick start such a moribund economy. Besides the best efforts of Washington have been severely undermined by the contagion of budget balancing and cost cutting that swept through our various local governments. That’s why the total government stimulus is much smaller than a cursory look at the Federal level indicates. Perhaps the pundits forget that we are 50 nations plus the Feds? In any case the accumulated impact of the State and Federal is way smaller than the already paltry amount that comprised the Fed stimulus alone.

My take on the stickiness in employment is that corporate America has completely altered its view of its workforce. We have entered a period of dissociation between employer and employed. Workers are simply a cost to be shunted off at the least provocation and hired only in the extreme. Lean management and flat hierarchies imply much more swift workforce reduction and mush less rapid workforce growth. This is not a new phenomenon of course. We have been discussing the destruction of the social contract and America’s more flexible workforce for decades. But it is only during the last two recessions – 2001 and now – that the real impact of this social change has been manifest. If you recall one of the great criticisms of George Bush was that his presidency produced the most anemic job market in American history. His record was lamentable. We are now experiencing the same shallow curve of recovery that we went through after the 2001 recession, only this time the devastation was so severe that, at our current pace, we won’t get back to pre-recession levels of unemployment for another two or three years. American businesses have protected profits, but at the cost of massive and prolonged unemployment.

The social implications of this are enormous and will only be apparent in the years ahead. Perhaps the most corrosive is that the balance in incomes in the American economy will continue to swing away from the average worker and towards those who make their living off of dividends and interest. Unless workers can reacquire sufficient clout to take a share of the increased productivity that the jobless recovery is now producing – and at some point that should be inevitable – then the distorted distribution of wealth we have created over the past three decades will be worsened.

This would have the effect of making future recoveries more difficult still. A larger concentration of the nation’s wealth in the hands of a few makes consumption, a key to the overall health of the economy, less responsive to the business cycle. People who already have wealth are less inclined to spend during a recovery than people who are less well off and are, therefore, more likely to spend any increase in income that comes their way. It is this phenomenon that makes the distribution of income a matter of concern to us all.

Apart from this, I also disdain looking at the job market as if it were one entity. Employment tends to be local and is driven by demand. That is to say that national wage levels are far less important than the level of economic activity itself in determining the shape of the job recovery. Couple this with corporate America’s obsession with short term profits and its lean management style, and I think the reason for the sluggish recovery in employment is obvious: demand is too low, and businesses want to syphon productivity improvements into profits rather than expansion.

Which brings us to another repetition. We need more stimulus if we truly want to break free of the grip of recession/poor growth.

I won’t bang that drum today, but rather I will point to the continuing quiescence of bond interest rates as a sure sign that the credit markets are betting more against than for the recovery. There are signs of life: industrial production kicked up a little last month, so our factories are gaining, not losing, momentum. But that data was more noticeable as an outlier than as just one more good statistic. The economy is obviously weaker now than six months ago, so I see no reason to expect a surge in hiring. At the same time I see no huge downside either. The most likely trajectory remains slow growth for the rest of the year and into next. With most of the risk on the downside.

And thats not news.

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Real Estate Drifts Lower … Again

There is, of course, nom news in the headline that the housing sector is still sliding rather than recovering. The only reason that the decline appeared to have been arrested as the enormous effect of the government stimulus. That poured enough cash – in the form of tax credits – into the industry to limit the rate of decline late last year and even to produce a few months of very slight recovery early this year. With that part of the stimulus package now history we are left looking at the ‘raw’ activity underlying the stimulus induced level.

It’s not a pretty sight.

In fact its downright awful.

Housing starts dropped a further 5% in June, following May’s huge 15% collapse. The effects of the tax credit can be sen in the lopsided figures for the year so far: completions of new homes – most of which were started after the credit was announced – shot up to an annualized rate of 886,000 in June; but the number of houses under construction, but not complete, plummeted to 450,000, the lowest number on record. Talk about whiplash. This odd set of numbers culminates in the fact that the inventory of unsold new homes now stands at a 40 year low. Clearly the industry is dormant. Yesterday’s release of confidence amongst home builders confirms this: only 1 in 7 have an optimistic view of the next few months. That’s an ugly statistic, but at least it’s up slightly from the rock bottom it reached last year.

Lastly, permits for new home construction, which is an indicator of future construction, rose 2.1%, but that gain was purely due to a few large multi-unti projects. Permits for single family homes dropped 3.4%.

Overall, the state of home construction can be summed up by this: starts are down 5.8% from this time last year, and 76% from the peak reached in 2006.

Why?

The bubble.

Real estate is still expensive compared with the other sectors of the economy. Home prices are above market clearing levels, and even though mortgage costs are at all time lows, purchasers are still way too wary of job prospects and possible wage declines to undertake a long term commitment. Since the economy appears to be headed into reverse at the moment, I doubt that there will be any substantial recovery in real estate until well into 2011. Indeed, I think things will slide a bit further unless the economy perks up soon. And that is not going to happen.

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The Rotten Thing About Real Estate

Once in a while I come across an article that hits a major problem head on. More often than not those articles are written by Martin Wolf of the Financial Times. Today he does it again with an analysis of housing. I would give you the link, but the article seems to have slipped from the FT website. Go find it if you can.

For those of you who are content with my summary, here goes:

Real estate is a scam. It is a pernicious scam to boot. It distorts economic policy, and it causes otherwise sensible people to make idiots of themselves by speculating on property values. Moreover it represents a massive attack on future generations.

There.

The argument goes like this:

Anyone who buys a home is a socialist. They are speculating in an asset whose value only accretes if the community acts together to rig the market and otherwise extract wealth from future generations. They do this by enforcing planning codes and other attacks on the free market for land. They subsidize the cost of ownership through huge tax abatements: both at the national level – as in mortgage interest rate relief – and at the local level – as in the tax credit for property taxes. So the rise in value of a property hinges mainly on the efforts of society. Yes, an individual who keeps her home in good order will extract more wealth than a messy neighbor, but the majority of the gain in house prices is directly a result of the community at large acting to ensure land ownership is a privileged activity.

Wolf sensibly asks the question: with the value coming from socialized activity do we then socialize the profits?

We all know the answer. No. We privatize the profits.

In fact we gloat over how clever we were to ‘invest’ in this particular home.

The distortions that this land speculation heap on the economy are manifest and manifold.

It twists the banking system into contortions. Mortgage lending is a long term activity. Bank deposits are short term in nature. This means that banks have to lend long and borrow short, which leads, inevitably, to periodic credit crises. About every eighteen years to be precise. During those crises home owners bewail their ‘loss of value’ and force governments to act to ensure a return to inflation. They also force the bail out of the failed banks. Meanwhile the media announces breathlessly, as a sign of strength in the economy, that home prices have returned to their inflationary path.

Imagine the agony of the press were that inflation to be in food costs. Or energy prices. A mere dollar or two in the price of a gallon of fuel and the country goes bananas. A surge in home prices and the nation gets a smug warm feeling that it has done well.

Folks: inflation is inflation is inflation.

I remember, well, sitting in a limo with Alan Greenspan and arguing that the CPI was an incorrect measure of inflation precisely because it failed to account for asset price increases. I have tried to hammer that point for as long as I have written about economics. Real estate should never be an ‘investment’. It is a rent substitute. Owning a home should not become an inflation hedge, nor should it become a source of inflation. Had home price inflation been properly accounted for in our measures of inflation, the recent bubble would have been nipped in the bud. Greenspan would have had to raise interest rates in the early 2000’s. The bank crisis would not have erupted. We would not now be facing ten years or so of miserable economic activity. And eight or nine million more people would have jobs.

That’s how pernicious real estate can be.

Only bad things befall societies obsessed with privatizing social gains on the scale that US seeks to do with housing.

Kudos to Wolf for spitting into the wind on this issue. I doubt he will make headway. The average home owner doesn’t want to face their secret socialist inner self. Instead they want to rob their children of the inflationary gains that they think they have ‘earned’.

One last thing: all those amongst us who gnash their teeth at the erosion of American competitiveness should sell their homes immediately and invest in the stock market instead. Every penny syphoned off from investment in industry because it is ‘invested’ in a home, is one less penny that we can deploy into making our businesses more competitive. Real estate is a useless place to put your money. It produces no productivity gains for the future. It is sterile. Only speculation in manufacturing and other businesses can build our store of future wealth. By being so self-regarding and privatizing the social gains of land ownership we have hobbled future generations of Americans.

That’s the rotten thing about real estate.

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Those Mystery Debt Issues

OK. Let me take another stab at this one.

There is no debt problem.

Now enjoy the summer.

We are beset with folks arguing that nations running big budget deficits ‘need’ to cut spending in order to assuage the credit markets. I have tried to argue this is fallacious reasoning, yet the fear continues. Indeed, every time it dies down, it pops right back up in a slightly modified form.

So let’s be logical.

First: there is absolutely no evidence in the credit markets of even mild concern, let alone panic. If there is one market where we should have confidence that current prices reflect a consensus view of the economy’s future, it is the market for government debt. History tells us that price movements in that market are a pretty good indicator of what the investors in government debt are thinking. And, by and large, these investors are amongst the most sophisticated there are anywhere. So the price of government debt is something we should pay attention to as an indicator of the sentiment – mood, outlook, or forecast – of these sophisticated investors.

What do current prices tell us?

That those investors are far more concerned about the likelihood of depression and deflation than they are about excessive debt and inflation. Interest rates in the market have dropped from the slightly higher levels they were back two years ago. Bond auctions are over, not under, subscribed. People are actively searching for government debt as a ‘safe’ investment. Let me repeat: rates are down, not up. Investors are scooping up, not divesting government bonds.

I happen to agree with the credit market’s conclusion.

The risks inherent in our current position are mostly downward. We are far more likely to fall into a repeat recession, and possibly a bout of deflation, than we are to boom ahead and run into unmanageable debt burdens and inflation. All of our most recent indicators show the economy slowing down from what was a very short and uneven burst of growth last fall and early this year. Austerity measures are simply adding to the downward pressure and ensuring that the slight chance of a boom is firmly eliminated. The credit markets are telling us that they recognize this and evaluate the future through a pessimistic lens.

That pessimism is driven, not by excessive debt, but by deficient demand.

OK. So maybe they’re wrong, and the ‘gut’ feel of the austerity advocates is right. What can we say to defuse that?

Second: take a look at worldwide cash flows.

The aggregate shortfall of demand worldwide is creating a staggering amount of cash. This is simple arithmetic. If people are earning, but not spending, they have an excess of cash. They become creditors. The global private sector is generating about $3 trillion in spare cash each year at the moment. Don’t forget that it is the private sector in retreat when we have a recession. So private sector savings have shot up. This includes businesses who are sitting on ‘war chests’ of cash, consumers who are paying down credit cards, and everyone else who is simply not spending. With consumption and investment this slack, the world is awash with cash. And cash is useless as an investment in itself.

So what happens?

People look for places to invest. One such place is government debt. In other words governments create debt to offset the step drop in private sector demand, and the private sector buys that debt rather than take the risk of making direct investment or consuming. So the sytem comes back into balance.

It is only when the private sector starts to see better investment opportunities within its own domain – i.e. within the private sector itself – that problems could occur. In this case investors would want to withdraw their cash from government debt and invest it in higher return, but also higher risk, projects and activities. This point of change in the attitudes and flows of cash is what could cause a run up in interest rates. Only then does the larger money supply implied by the bulge in government debt become a potential inflation problem.

It is at this moment that government funding strategies need to change course and the private sector be allowed to forge ahead.

We are nowhere near that inflection point. This is the constant and firm message from the credit markets.

In fact, if anything, those markets are crying out for more debt and thus more stimulus.

Ah … but what about all this debt? Is it not a burden on the future?

No.

It is an investment in creating that future.

The cost of living through a period of very low growth, and potentially through deflation, is vastly greater than the cost of the debt necessary to reflate growth and get GDP back to its historic levels. The higher rate of growth will allow the debt burden to be reduced as a percentage of the economy. The cost of the debt as a percentage of total government spending will increase, but as a percentage of the total economy it will be a minimal increase, if any.

People who wring their hands about passing on debt burdens to future generations would be better advised to focus on the economy itself. Given the choice between an anemic economy with low debt and a vibrant economy with higher debt, future generations would be stupid to choose the former over the latter. Vibrant growth begets opportunity, and ways in which to pay down debt, that are not on offer in a sluggish economy. And it is opportunity we should be handing down to the future, not our own fearful withdrawal from growth. In other words we should not enforce our own view of austerity on the future, but seek to create the opportunity for future generations to make their own choices. The best way to do that is to get the economy back to healthy growth.

Does this mean we have no fiscal issues?

No.

I have repeated timer and again: we have major budget funding issues to deal with.

But they do not relate to the recession, or the debt needed to fend off depression.

They relate to our fundamental choices: how to pay for retirement and health care, how to pay for defense, and how to offset the imbalances that our economic freedom produces within society. For the past thirty years or so we have followed a relentlessly self-regarding path with respect to those choices. We have focused on the self and not the community. Individualism trumped society at every turn. That created great wealth for some, and a massive redistribution of the economy’s earning power away from the middle class to a much smaller percentage of the population. It exposed the fragility of the middle class, which was a post war phenomenon based upon a very different social arrangement. It returned much of that middle class to the edge of poverty – month to month living – and away from the ‘American Dream’ of comfortable retirement ‘earned’ by a life of virtuous hard work.

The hard economic reality is that virtue and hard work do not guarantee anything. We are now learning that. The institutions put in place after the Great Depression to mitigate this hard truth, and to allow the middle class to enjoy a modest version of the life the wealthy have always enjoyed, were swept away once we started to view them as encumbrances or barriers to our continued advancement. We were beguiled into thinking we could all be rich, if only those institutions were abolished. Instead, we simply watched society revert to the older distribution of wealth, with more and more of us ‘doing the right thing’ but still being left behind.

A particularly hard lesson is that the focus on the individual withdraws funding from the community. Our bedraggled infrastructure speaks volumes about our choices. We assumed the roads, rails, and schools would repair themselves while we bought retirement homes, played golf, and had our faces and various other body parts uplifted.

Which brings me to one last comment about debt:

As always there are two sides to the story. Debt and deficits can be productive or they can be destructive. A debt created in order to invest in a productive asset is never a bad thing as long as that asset pays more than it cost to put in place. Government spending on infrastructure, and even on consumer protection, falls into that category. But debt that is incurred without a productive use is both frivolous and, ultimately, damaging.

This is where the debt fearing amongst us have a point.

Most of our current debt problems relate to the Bush tax cuts that produced no lasting wealth creation. They were simply a shift of wealth from one segment of the population to another. GDP did not rise in response to the massive debt we incurred to pay for those tax cuts. Nor did investment. We have no enduring infrastructure. We have no new roads, rail systems, no new schools, no great research initiatives, and no burst of private sector invention. All we have is appalling job creation and an enlarged number of marginally poor people. Oh … and two wars. There is no asset being passed on to the future, simply a problem.

The problem being that we refused to face our limitations. Or that we were limited at all. It became ‘unAmerican’ to talk about the limits to growth. It was ‘unpatriotic’ to mention that we needed to make choices explicitly. Instead we were led into a period of avoidance and implicit choice. The cynicism of which is breathtaking. How else we we justify the Reagan deficits? How else do we explain the plunging into debt that the 1980’s brought us? How else do we explain our apparent comfort with the 2011 expiry date put on those Bush tax cuts? It seemed like a long way off at the time. And we didn’t care about the dire budget consequences we would face when the expiry came up. Instead we basked in the few extra dollars we all received at the time. As an example of extreme fiscal folly, those tax cuts, and our complicity, are hard to top. It is extraordinary that the generation culpable for that series of decisions is now suddenly concerned about fiscal rectitude, just as the baby boomers ‘threaten’ the stability of the budget that they denuded of funding.

Perhaps it is this that so disturbs many folks that they are now fearful of all debt.

If so I hope I have reduced that fear and helped focus us on the real issues.

So allow me to end this by repeating, and modifying, my opening line:

There is not debt problem.

But there is a choice problem.

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Deficits and The Economy: Time To Get Worried?

The big question now has become: are we falling back into recession?

Who knows?

There is plenty of evidence mounting that the US economy is slipping back from its early recovery pace into a much lower, and therefore more risky, pace. The downward revision of first quarter GDP, from the original 3.1% to the more recent 2.7% is just one example. The stubborn refusal of private businesses to hire workers is a sure sign of that sector’s collective gloomy and fearful approach – private sector hiring is still anemic and was insufficient to offset the seasonal lay-offs of government workers brought onboard to do the census. Real estate is mired in a deep slump and shows no sign of recovery. On the contrary each report on housing seems to ring up a new historic low for activity. And even the springtime euphoria in manufacturing has now given way to a two month drop in factory business as measured by the Institute of Supply Management. US factories appear to be suffering the backwash from the Euro zone difficulties, where European austerity plans imply less imports from America.

In short nothing looks as rosy as it did back in April and May.

It is in this weakening context that we should assess policy. In particular we should take a good long hard look at the Federal deficit.

I have beaten this drum incessantly, so bear with me one more time.

Now is not a time to reduce the stimulus. Not at all.

Yes, that implies big and growing deficits. But, as I have stated many times, a big portion of that deficit is cyclical: it will go away when – and if – the economy picks up a head of steam.

And, yes, we have a definite and large deficit problem. We spend far too much on defense and on health care. We cannot afford to keep those expenditures at their current level without getting a more secure funding for them over the long haul. Our deficit problems are rooted in the insane and reckless budgets of the Bush era, not in the emergency and temporary measures of the Obama era. We need to keep that in mind as we argue over the next step in policy.

Take a different tack: if we adopt austerity measures now, or even in the next few months, the odds of a repeat recession shoot up rapidly. There is absolutely no evidence that the private sector is ready, willing, or able to carry the load. Just the opposite: businesses appear only too willing to reduce themselves in order to protect profit in the short term. This weakness and timidity sets in motion the classic downward spiral of the a ‘paradox of thrift’, which only the government can break.

In my mind the world’s leaders have gone crazy: they are all so hell bent on budget cutting in order to appease the credit markets that they have forgotten the long term consequences of their actions. They are all willing to abandon long term health for short term ‘confidence boosting’. As if the markets can’t see the devastation that could arise from this austerity mania. There is almost a collective reverse bubble psychology at work. No politician wants to be sen as ‘weak on deficits’. They conveniently forget the lessons of the 1930’s and rely instead on the economic theories of the last thirty years. But those theories are bankrupt. They were wrong when they were first floated, and they have been exposed as wrong by this crisis. Quite why otherwise intelligent people are still clinging to those policies baffles me.

Inertia?

Ineptitude?

Ideology?

All of the above.

Take the Germans: in good teutonic style they adopt austerity in order to get their house in order. They neglect to note, or admit, that their economy is built upon foreign consumption. That consumption sucks in German goods. So as long as the rest of the world is willing to remain profligate the Germans can be austere and feel good about being ‘correct’.

But: what if the rest of the world also gets a bout of austerity?

Who will buy those German goods? Not the Germans. They are facing austerity cutbacks. The austerity logic breaks down when the entire world goes in the same direction. There is no one to provide the consumption necessary to drive the world growth machinery.

This is why the Chinese have become so important.

The financial markets, and the more optimistic folks in the financial media, have been relying, in their forecasts, on Chinese – and to a lesser extent the rest of the emerging world – to maintain demand so as to allow the ‘old world’ to make the painful budget adjustments they need to without falling back into recession.

Which is why the most alarming news this week has been that the Chinese economy is showing very distinct signs of slowing down.

Get ready for a nasty shock later this year when the GDP numbers come perilously close to zero. Especially as the effects of last year’s stimulus fade away. I still expect us to eke out growth over the near term, maybe in the range of 1.5% to 2.0%. But it doesn’t take much – a Chinese slowdown and all that Euro austerity? – to eliminate it.

Which brings me to a question often asked: the pile up in US debt is presumed to have bad consequences. Especially: the credit markets are presumed to be jittery about our budget. How dow we know when the threshold is reached and the world won’t support our profligate ways any longer?

The short answer is that no one can possibly tell. The longer answer is that I don’t really care anyway.

The reason is this: with the world in a swoon, money has to go somewhere. The US is still, by far, the world’s largest economy, and it is still very stable. Yes the US has long term imbalances that must be eliminated. And, no, there is no sign that US voters will support the kind of cuts needed – can you imagine a Presidential candidate advocating defense spending cuts along with a increase in the retirement age and proper health care reform? We have just been witness to the deep rooted divisions in the US that prevent fiscal rebalancing. It is unlikely that we will succeed any time soon.

But: the rest of the world is in such bad shape that even a profligate and badly managed America looks safe. How else do we explain the drop in US bond prices? Were we reaching the threshold of pain for our creditors and early sign would be their unwillingness to buy our debt. Our bond prices would be rising. This is not happening. Bond prices are falling and demand for our debt is rising. In other words we have a huge capacity – still – to borrow.

We should use that capacity in order to guarantee our recovery. Our borrowing capacity remains one of our greatest assets. We should increase, not decrease, government spending to fill the demand gap. Those bond prices tell me that the markets are fine with the deficit. For now.

Which brings me to another question: are we spending our money wisely?

Not at all.

We are pouring it down the sink holes of two needless wars rather than into programs that have strong stimulative effects. Defense – offense? -spending has nowhere near the impact that increasing unemployment payments does. Neither come close to grand government works programs. This is the proper criticism to level at the anemic stimulus program of last year. And yes, it was anemic in the context of our problem.

Politics prevents us from solving the problem: we have to water down all our programs in order to reach ‘compromise’. We cannot get enough votes to extend unemployment relief even though the cost of so doing is but a week or two of our war expenditure. We have to include specious tax cuts even though all the evidence – and there is tons of it – tells us that tax cuts are just not stimulative.

Which brings me to the real reason to be worried:

Lack of leadership.

From the White House, to the opposition, to business, to academia, to ourselves. No one is willing to think on the scale that the crisis deserves. No one is willing to stand firm against the pull of the mushy center. No one wants to take responsibility and eliminate the fear that pervades the economy. Everyone, it seems, is afraid.

And that simply begets more fear.

And it leads us into wrongheaded policy making, like austerity at a time of slack demand.

That’s why I am worried. You should be too.

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