Bipartisanship?

Good one.

Scared of the 800-lb. Gorilla?

Went to an interesting symposium on the economic crisis and the Obama policy response/spending bill yesterday. Two economists, Tom Campbell and Barry Eichengreen, gave their interpretations. What struck me was that nobody, especially nobody in politics, seems to want talk about the 800-lb. gorilla in the room. This beast is the pervasive uncertainty associated with price discovery roiling all markets and asset classes. This 800-lb. gorilla is partly psychological but also real, so perhaps we can talk about the big gorilla and his even bigger shadow.

Policymakers don't want to bring too much attention to the gorilla for fearing of scaring the public with his imposing shadow. But in so doing they seem to be pushing a form of denial that is also reflected in the proffered policies. Most of these policies seem targeted to further obscure prices or prop them up. Obama's proposal to throw another $275 BILLION at foreclosures in the housing market is a case in point.

The necessity of price discovery is crucial to clean up the banks and get credit flowing again. What do we think these toxic assets are? They're assets that nobody can agree how to value (most of them based on unrealistic housing prices). The market has depreciated these assets to 30-40 cents on the dollar, but the owners (banks) think they're worth more, but can't sell them and are hoping the government (i.e, sucker taxpayer) will buy them at par. At least that pig didn't fly. But if we don't discover prices on this toxic dump we can expect years of zombie banks in our midst. Expect some nationalizations and then break-ups.

True price discovery is also crucial to getting the housing market off the mat. Nobody is going to buy overpriced housing no matter how cheap and available credit is, and nobody is going to convince them that prices have stabilized by virtue of directives or hopeful words from Washington. What's a house worth anyway? The "bigger fool" strategy is history for now. Let's try a historical metric of cashflows off implicit rents or median incomes and we'll get an idea. A house that rents for $5000 a month is worth maybe $900K. Rents for $1500/mo. = $270K. But policymakers want to stabilize house prices based on inflated mortgages. Ain't gonna work. Just more wasted dollars...

But why? How are we helping things by encouraging people to buy or stay in overpriced homes they can't afford and then sticking them with the bill over the next 20-30 years? Are we searching for new ways to impoverish these people? How are they going to pay for the expenses of old age? Wonder how that's gonna work with our entitlement reform?

Bottom line is that nobody wants to adjust housing prices to the downside. But there's no other way out of this mess. Securitized mortgage money is gone...buying power is a fraction of what it was in 2006. Let's get real instead of throwing good money after bad. Indications are this is gonna take longer than we think.

Joe the Renter?

Date: February 6, 2009
Re: A memo from Joe the Renter

Dear Congresspersons, Senators and Mr. President,

We are in the midst of a serious economic correction and the causes are quite complex. As a prospective home buyer allow me to narrowly focus on the state of the housing market. There have been many calls from the Capitol to save home owners facing foreclosure – a moratorium on foreclosures, new government-subsidized fixed rate mortgages, loan renegotiations, and bailouts for lenders. (BTW, these owners underwater don't want to be saved and tethered to their bad investments - they want to be liberated.) But precious little has been focused on the people who can afford and wish to buy a home. Don’t we want buyers to re-enter the market?

For a home buyer, I have the desired qualifications: middle-aged, recently married, with a combined income that varies between $80-150K, zero debt, a credit score over 800 and roughly $300K cash that could be put toward equity. What matters most to me is the size of the mortgage and the prospects for price stability or, better yet, long-term appreciation. In the long-term it doesn’t matter that I might get a $7500 purchase tax credit or a low interest rate because these factors will just keep asking prices higher and increase the size of my mortgage principal owed. You could offer me limitless funds at 0%, but I still will not borrow to buy an asset that is overpriced based on cash flow fundamentals.

The problem in a nutshell is our national housing stock is overvalued by almost any economic measure we use, whether it be median incomes, imputed rents or national GDP. Currently we rent a 2200 sq. ft. home for $2800/mo. Comparable houses in the area of Los Angeles where we live have asking prices of $1.2-1.5 million. Buying just doesn’t compute. Because we live in a dense urban area of Southern California I know many other families in the same predicament – on the sidelines with cash waiting for a rational market to return. In the current environment we will all continue to rent and put our investments elsewhere.

You might think my take on this is self-interested, and I would wholeheartedly agree. But my actions have been financially prudent. I need to save money for retirement, not throw it away on overpriced housing. I did not “roll the dice” on subsidized housing with other peoples’ money. But the nation is in the same boat.

We made bad investments in an asset bubble. We need to correct these prices, not distort all the other prices in our economy. Otherwise we will be in a deeper hole when it comes to financing our retirements. We can make housing affordable in this country if we stop subsidizing it over other investment classes and let it return to true market value. The political challenge will be how to manage the losses this will incur to those who were not so prudent – buyers, lenders, banks and investors. I suggest you leave us taxpayers out of it as much as possible.

Sincerely, Joe the Renter

P.S. While I am an average citizen and home buyer, perhaps I am not the typical voter. I’m a macroeconomist, finance MBA and political scientist. I hold doctoral, masters and bachelor degrees in these three disciplines, all from top-ranked schools. Thus, I am one of the so-called “experts” you often consult for policy advice. Please take it into consideration.

A Crisis in Prices

Dick Armey wrote an op-ed in today's WSJ applying the lessons of Hayek to the financial crisis. In this case, Hayek provides the right diagnosis - the problem we have is in the price system. Government spending can and usually does distort the price system in unintended and counter-productive ways. And it does little to address the immediate problem of flagging confidence.

The present crisis is marked by the distortion and uncertainty of prices that has instigated a lack of confidence in risk-taking behavior. When prices readjust, confidence will slowly return, but we can't wait that long. A stimulus bill focused on demand will not correct prices and affect the crisis in confidence until it affects the real economy a year or two out, but we can't wait that long. Think how long it took for New Deal policies to have a positive effect on the Great Depression. Anybody want to wait that long?

Policy should be directed at those signals that will have an immediate psychological impact: permanent reductions in taxes on productive activity. Commitment to compensate for the dislocation costs of this economic correction through automatic stabilizers can also help alleviate consumer and employment fears. The system's imbalances need to correct, but it's the continued uncertainty that will exact a greater cost.

Our current crapshoot politics and best-guess economic policy may be the worst alternative that may come all too soon.

Mortgage Slaves?

Finally, someone has spoken the unspeakable on the foreclosure crisis. In today's WSJ there's an op-ed titled, "Why Be a Nation of Mortgage Slaves?" (subscription req'd).

The politicians have been spouting off for months on this--how it's horrible that homeowners have been the victims of the mortgage crisis and how they need a bailout or foreclosure moratorium to stay in their homes. These pols are blowing smoke. Nobody, I mean nobody, in their right mind wants to be forced to pay an oversized mortgage for an undersized house for the next 30 years. The question is who takes the haircut on these white elephants? The homeowner, the lender, the investor, or the taxpayer? Morally, I think the taxpayer should be absolutely last on this dance card.

I wrote on this before in my blog on Foreclosure Myths. Hopefully we can move the public conversation towards some kind of economic logic. If we want to make houses affordable, all we need to do is stop subsidizing them and let prices fall to a natural level based on comparable rents. We've got a long way to go.

Mass Confusion in Washington

Perhaps Washington's policy confusion will take a brief 2-day holiday next week, but then it's back to the hair of the dog that bit us. The confusion seems to be about what to do about the economy. All the talk is about which "stimulus" plan will give the most bang for the buck. Should we spend big on infrastructure? Pump up the private credit markets? Save homeowners? Increase social insurance payments? Increase tax cuts to business? Subsidize "green" energy? Bail out failing industries? Drop dollars from helicopters? All of the above? (If you're expecting our new president to magically come up with the right answers, you're living on a whim and a prayer.)

These folks seem to be missing the lesson the market has taken great pains to teach us. Almost all these options focus on pumping up collapsed demand - yet the demand collapsed because it was running on hot air. The real problem is that quibbling over whether a dollar of infrastructure spending or unemployment insurance yields more than a dollar of tax cuts is like rearranging the deck chairs on the Titanic. Now the Fed is even considering targeting a positive rate of inflation, so people can be assured that their balance sheets will gradually strengthen as their real wealth slowly vanishes.

Instead we should be focusing on how to get people back to acting on their risk-taking animal spirits. (People, mind you, private individuals--not government or its servants.)

We need to reexamine some simple economic truths:
1. Governments don't create jobs, private entrepreneurs and businesses do.
2. Governments don't create industries either, risk-taking investors and businesses do.
3. Inflating demand that is not built upon increased productivity and production is a form of illusion. Giving people money they can never pay back to buy stuff they don't need isn't going to fill anyone's coffers with profits, only losses.
4. National economies grow when people work more, produce more, save, consume and invest. Government can't accelerate this train by pumping up one or another of these activities.
5. The best any government can do is set up the rules of the game and the playing field so private citizens can produce wealth. Then get out of the way.

We can see that very few of the policy proposals square with these fundamental economic truths. The problem we face now is that we've allowed behavioral incentives to become distorted to favor some actors over others. We bred excess and then fed it. Now government is leaving its big paw prints over everything. This only counteracts any positive incentives that may arise from this financial correction.

Asset prices, especially housing, have been totally distorted by the vicissitudes of policy. Public pronouncements of what prices "should" be can only add to the uncertainty. Some corporate and private balance sheets are flush with cash, but as long as the distortion and uncertainty goes on, the longer they will stand on the sidelines and wait. The bigger danger of the housing market is that it will take years to reach economically rational prices, not that it will get oversold.

We should be providing clear positive incentives to all economic actors that directly bear upon their risk-return calculations and reduce their perceptions of uncertainty. Naturally, I favor tax cuts targeted to productive effort. No subsidies, bail outs or guarantees on outcomes. And it would be reassuring to know a dollar will still be worth a dollar next year.

As our policy-makers dither over different proposals to put Humpty back together again I hope they will focus on answering one question: will this policy encourage actors to take prudent risks without engendering moral hazard?

If the answer is not a resounding yes, let's skip it and leave well enough alone.

Comprehensive Election Analysis

Jay Cost and Sean Trende of RealClearPolitics posted the first installment of their 2008 election analysis today. You can find it here and it's pretty accurate in its interpretation. Their manipulation of the data cuts through most of the nonsense promoted by the media.

In short, there is still a significant urban-rural red-blue divide and Obama benefited mostly from the racial vote, both black and white. Thus, there is probably no real ideological shift within the electorate and Obama's fate will probably rest on the economy and any national security surprises. This is consistent with my own findings.