“The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the results of International Monetary Fund stress tests.”

We at CERF have been long concerned about the strength of our financial sector.  In fact I suspect that the IMF study may be understating the severity of the situation.  That would be a problem.  Ask the Japanese what a weak banking sector can do to an economy.  The weakness of their financial sector, and their failure to correct those weaknesses, were a significant contributor to their 20 years of economic malaise.

Failure to promptly deal with our weak financial sector can have similar consequences for us.  You may think the new financial regulation fixes our banks.  It doesn’t.  It creates a new regulatory environment but it does nothing to address the problems that are keeping our banks from fully participating in our economy, inadequate capital and bad assets on their books.

The paper is clear, and that’s not what I’m confused about. I’m confused because Christina Romer is one of the administration’s top economists, and the insights in her research are not being reflected in policy.

Romer and Romer find that there is a large negative tax multiplier, perhaps over three percent. That is for one percentage-point change in taxes as a percentage of GDP, you get an opposite three percent change in output, GDP. So, a one percentage point increase in taxes, as a percentage of GDP, results in a GDP decrease of about three percent. Conversely, a one percentage point decrease in taxes generates about three percent GDP growth.

The size of the tax multiplier stands in stark contrast with the best estimates of the spending multiplier. For example, Valerie Ramey, in a very recent paper that is currently unpublished but will surely be published in a top journal, uses a methodology very similar to the Romers’ and finds the spending multiplier is positive and in the range of 0.6 to 1.2.

The implication of the research is clear. Tax policy is a far more powerful economic stimulus tool than is spending policy. Why isn’t this research reflected in current policy?

Beats me.

Given the popular belief that economic conditions are important to a party’s reelection, ignoring this research appears to be irrational.

The Romers’ paper has other insights. One is that the purpose of the tax change seems to matter. Tax increases intended to reduce deficits are less harmful than a random tax increase. The authors speculate that part of this phenomenon is that tax increases to reduce deficits are usually accompanied by complementary spending cuts.

The most fascinating result is that the multiplier works mostly through investment. A tax increase has a small negative effect on consumption, but a large negative effect on investment. Similarly, a tax cut’s stimulative effect is mostly through investment and not consumption.

These findings have important implications for today. A lack of investment is a key characteristic of this business cycle. If we are in a recovery, this is why it will be so weak. Obviously, raising taxes would be the opposite of a stimulus, and best avoided for now. Instead, we need the mother of all investment tax credits.

I argued that the United States economy is now in an intermediate equilibrium, one I call the “good-deflation” equilibrium. This is where consumers see low price growth as helpful in maintaining moderate spending in a jobless economy, producers see low price growth as helpful in maintaining costs, and the FED is able to maintain historically low interest rates without worrying about inflation.

What are the factors that might drive an equilibrium shift from today’s good-deflation equilibrium to a bad-deflation equilibrium? We need factors that measure how people feel. We would like to know how households view their current economic situation, how firms view their current situation, how banks view their situation, and how investors might view the future.

Prototypical measures of these items are: the consumer confidence index, the business sentiment index, the Ted spread and/or the normalized Ted spread, and interest spreads such as the Baa–Aaa or the Aaa–TB10Yr. The Ted spread is the 3-month LIBOR minus the 3-month Treasury, and the normalized measure divides the Ted by the 3-month Treasury. We show pictures of these measures in graphics below.

Interestingly, financial market measures clearly show late 2008 and early 2009 as being times of regime shift, whereas the various measures of consumer and business sentiment do not show this as clearly. I believe that based on these indicators and on broad measures of economic activity like GDP and jobs that the United States economy shifted to an equilibrium characterized by freezes in credit and risk-taking in the fourth quarter of 2008. In the third quarter of 2009 the economy shifted to better equilibrium, one still in force now. This is the intermediate “good-deflation” equilibrium discussed earlier.

What do these indicators tell us now? The blue line consumer confidence measure on the Consumer Sentiment graphic fell dramatically every month from July 2007 through 2008. Since then, it has remained flat at a very low level. This might not be a good sign. The various credit spreads indicate that conditions are much better now than they were in late 2008, but conditions have not returned to normal.

Both of the bond spreads shown here have been climbing rapidly for 2 months. If this continues many more months we would have a key indicator telling us that those market conditions were changing or had changed to a worse equilibrium. This would not necessarily mean the entire economy had changed. I would be more convinced the entire economy had changed or was changing to a bad equilibrium if all of the indicators move dramatically in that direction.

I urge our clients to watch these indicators. I will monitor them, and provide occasional updates in this blog-space.

“Home Vacancies Rise as U.S. Ownership Falls to Lowest in Decade.”

Most will take this as bad news, and it is, but not for the reasons many will think.  Most will lament the decline in home ownership, as if it is somehow a slide away from the American dream.  It’s not.

The real problem with the data release is that it shows us that too many still own their own home, and the rate of home ownership is not falling quickly enough.  Bear with me while I explain.

First, we need to agree that not everyone should own their own home.  Some people’s circumstances or personalities are such that home ownership is just not appropriate.  They may need geographic mobility.  Perhaps their income is not steady.  They may lack the discipline home ownership requires.

Once we agree that not everyone should own a home, the question becomes: What is the appropriate percentage of home ownership.  Economic theory gives us no answers, but the data do.  For the United States, it appears that about 65 percent is the highest sustainable rate of home ownership.

Home ownership rates started climbing above 65 percent in the 1990s, a result of well intentioned and deliberate public policy.  Eventually, America’s home ownership rate exceeded 69 percent.  That is when things began to go seriously wrong.

Unfortunately, governments have been doing their best to prevent or delay us from getting back to the stable 65 percent.  The result is that it has taken us two years to get from our high to today’s 66.9 percent.  Getting under 67 percent is encouraging, but we need more before our real estate markets are healthy.  At the rate we’re going, that could be a while.

“epidemiology in the nineteenth century was much like economics in the twentieth century: a subject of intense public interest and concern, in which theories abounded but where the scope for controlled experiment was limited”  Cooper

The most fanatical Keynesians are losing their composure. Brad DeLong, a prominent Berkeley economist and Keynesian, is virtually yelling that “We Need Bigger Deficits Now!”, emphasis his. Paul Krugman does DeLong one better, calling proponents of fiscal responsibility madmen.

They are following the gospel of John Maynard Keynes, who famously advocated government deficits to pay people to dig holes, increasing demand and therefore economic activity. This is, to be polite, bunk.

It is worse than that actually. The logic implies that any government expenditure funded by debt will result in sustained economic growth. The result has been a stimulus plan that completely lacks coherence. Instead, we have a hodgepodge of spending initiatives that provide a temporary illusion of growth, but that will leave us with little that is long-term, except for huge hangover of debt which will be a drag on economic activity for years.

Keynesian stimulus theory comes about because of what is called a liquidity trap, a situation where the interest rate is zero, because no one wants to invest. The logic is that you can spend your way out of a liquidity trap; that by spending, government can increase sales. Eventually the increased sales will cause businesses to invest, driving interest rates up.

It is an article of faith among Keynesian economists that if the stimulus is big enough, it will generate sustained long-term growth. Call this the Tinkerbell Principle. You only have to believe in animal spirits to have expectations of a better future.
Consequently, when the spending doesn’t achieve the desired result, Keynesians always call for more deficit spending, just as we see in the above-linked DeLong and Krugman arguments. And, when that doesn’t work, like a broken record, they will call for more, but there can never be enough.

There is a case to be made for expectations, but they need to be rational. The recession was similar to a bank run, which can kill a bank, even when there is no initial weakness to generate the run. In this case, we had a run on the world’s financial system. Call it a regime shift from a good equilibrium to a bad equilibrium.

Can government spending alone bring us back to a good equilibrium? It can if you believe in animal spirits, but I don’t.

I believe that people are not excessively stupid. Economists call this concept rational expectations, the idea that most people can see obvious consequences most of the time.
I believe that people spend out of wealth: the value of the assets they hold and the present value of future income. This may not be an easily calculated number, but people keep track of it. It is something like a fielder’s response when a batter hits a ball. This is a complex problem, but fielders respond instantly. The fielders are moving in the correct direction at the correct speed to intercept the ball while the bat is still in motion.

Finally, I believe that people try to smooth consumption. That is, they like to eat a little every day rather than go without for several days and binge on other days.

Let’s analyze typical deficit-financed government spending programs using these beliefs. Somebody is going to have to repay the debt someday. It can be the person who receives the money, some other person who is currently working, or some future worker.

If the person who receives the money is the one who must repay it, she will normally save it. Her wealth has not changed, she knows that she will have to repay the money, and she’s not excessively stupid. She’ll want the money there when she needs it. We saw this with the Bush “tax rebates.” Consumers saved the rebates, and the administration did not see the consumption boost they had anticipated.

There is another possibility though. She could be what we call ‘liquidity constrained’, holding no cash and unable to borrow. Her wealth is still unchanged, but she wants to smooth consumption — keep it at a relatively steady level — so she may spend some or all of the money. However, this implies that her future spending stream will be reduced. We’re taking from tomorrow’s economy to support spending today. This may be justifiable on humanitarian grounds, but it doesn’t generate sustained long-term economic growth.

Suppose it is another worker who will repay the government debt. His wealth has just decreased. He’ll spend less, and, also being a consumption smoother, he’ll start spending less right now. Again, there is nothing here to generate sustained long-term economic growth.

Finally, suppose it is some future worker who will repay the debt. He or she will enter life or the workforce with a debt. I’ll ignore the ethical implications of enabling increased consumption by current citizens by imposing, without consent, debt on future workers; instead, I’ll stick just to the economics.

Our future worker starts a career, absent some other endowment, with a negative net worth. Over the course of his career he’ll spend and invest less than if he had started with a zero net worth. Again, this is not a prescription for sustained long-term economic growth.

What we have to face is that by borrowing to consume now, we are taking away from the future. This is just not the way to achieve sustained long-term economic growth.

So what to do if you are a politician who thinks something must be done?

The liquidity trap comes about because no one wants to invest. What government should do in response is try to increase demand for investment. This would increase economic activity now and in the future. Increased demand for investment can be created by investing in public capital that makes private capital more productive, and by lowering the cost of borrowing.

When the government borrows and invests the money in projects that increase private capital’s productivity, it is increasing the return to capital. Increasing returns to private capital increases the demand for private capital and investment. Current and future economic activity is increased.
We have lots of examples of these types of investments, including canals, dams, highways, public utilities like the Tennessee Valley Authority, and more.

The other approach to increasing investment is to lower the interest rate. This is difficult to do directly when the interest rate is zero, but the government can achieve the same result another way. An investment tax credit effectively lowers investors’ borrowing costs.

So, if the government is going to actively stimulate the economy, it would be far better to invest in public capital that improves the returns to private capital. It will also help to provide a meaningful investment tax credit. Consumers could then rationally expect their future income stream, hence their wealth, to improve. With increased wealth their spending will increase, and we will be on our way to sustained long-term economic growth.

A year ago we were hearing all about green shoots. Analysts claimed to find them everywhere.
Today, we never see the term. In fact, there seems to be a growing malaise. By the end of June the first quarter’s Gross Domestic Product (GDP) estimate was revised downward a full half a percent, to 2.7 percent. Pundits are depressed. Our President and Secretary of the Treasury are telling the world that the United States cannot lead the world to sustained economic growth. Our Vice President announced that “there’s no possibility to restore eight million jobs lost in the Great Recession.” Our stock markets are down and volatile. Risk premiums have soared.

What happened?

Reality happened. The green shoots were always ephemeral, the result of massive government spending increases or temporary government programs. We had housing stimulus programs. We had Cash for Clunkers. We had foreclosure programs. We had bailouts.

The increased spending and the various programs had an impact. Because of the way GDP is calculated, an increase in government spending results in an increase in GDP, but that is today’s GDP, not tomorrow’s. Tomorrow’s economic growth is a result of investment today, investment in physical capital, technology, and human capital.

To the extent that government spending detracts from those investments, the growth we saw was cannibalized from the future. For example, the housing stimulus programs served only to change the timing of real estate purchases. Sales fell when the programs ended.

Even worse, some programs resulted in temporary GDP growth, but were actually detrimental to long-term economic growth. The Cash for Clunkers program destroyed capital, since perfectly good cars were crushed. The foreclosure prevention programs delayed the needed decline in home ownership rates.

The bailouts prevented assets from being transferred to more productive uses. Bailouts are inefficient, and they prolong periods of economic weakness. Uncertainty and risk premiums remain elevated, holding investment to a minimum, limiting short-term and long-term economic growth. They also leave a hangover of debt, which limits future growth.

None of the programs addressed the underlying problems of the current economic circumstances, or paved the way for sustained economic growth. The immediate problem was that businesses, consumers, and governments were over-leveraged after September 2008’s asset-value collapse. The longer-term problem was insufficient investment, a result of years of credit-fueled consumption.

What was needed was investment. What was provided was more credit-fueled consumption. You might be able to borrow your way to prosperity, but to do that you better be investing the borrowed funds. We didn’t do that. Instead we used the government as a bank to increase consumption. Credit-based consumption is not the way to long-term prosperity, regardless of who does the borrowing.

And, while it appears that most of the decline in asset values has ended, over-leverage is still with us. Indeed, the increase in government leverage makes it more difficult to employ effective government intervention, government investment in productivity-enhancing capital and technology, and investment tax credits.

Add to these factors the millions of American households, employed and unemployed, that remain over-leveraged. Millions of consumers have been unemployed for months, and many of those still working are uncertain about their future employment. Those who have the income to do so are attempting to pay down debt, and to reduce consumption in the process. The consumer is not likely to soon be a source of rapid economic growth.

So, we have most or all of the problems of a year ago, but now, because of increased government debt, we have fewer options. Even worse, we now have new problems that were not present in September 2008.

Today, sovereign default risks are significant and increasing. While potential sovereign debt problems in Europe have received a great deal of attention, the problems are not limited to the continent. Japan continues to have very high debt and deficits. Several U.S. states could also default. A failure of an American state is likely to have impacts very similar to the failure of a small European country.

I don’t believe that the failure of a country is the most likely outcome, however. Instead, expect to see more international bailouts, just as you can expect to see the federal government bailout several American states.

Our options are limited, but we do have one option that would provide immediate and sustained economic growth without increasing leverage. That option would be a massive increase in immigration.

The initial benefits of a new wave of immigration would be seen remarkably quickly. Housing demand would increase, leading to renewed vigor in our real estate markets and the construction industry. Our inner cities would be renewed, as they always have been by immigration waves. New business formations would soar. The tax base would increase, helping to fund debt repayment and baby-boomer retirements.

Many would oppose such an immigration increase. They worry about increasing job competition, unemployment, crime, and even more demand on welfare programs.

These fears are misplaced. Criminals are easily sorted out by effective screening processes. People don’t migrate for welfare benefits, but if this is a concern, it is easy to deny immigrant access to social programs for some number of years after immigration. Similarly, people don’t migrate to be unemployed, and unemployment benefits can be denied to immigrants.

People migrate to more effectively use their human and physical capital, their technology, and their labor. Effectively, immigration would provide new capital, technology, and labor. This is exactly what we need, and it is free. Immigration has served America well in the past. It can serve us well today.

The easy answer is the expiration of federal incentives on April 30th, but that is not enough.  For one thing, sales in May were still buoyed by the stimulus.  As long as the escrow was entered into before April 30, the sale could close in May.

Incentives do move sales forward.  I have no doubt that the tax incentive moved sales from the Summer to Spring.  Incentives also move sales to the future.  I’m currently considering purchasing a rental unit, but I can promise you that I won’t enter into a deal as long as I think another incentive is in the future.  I do think one is in the future.  I’m not shopping today.  I expect to shop in August or September.

Fewer homes being built is also a contributor to the decline in new home sales.  California building starts, reflecting previous overbuilding and very limited demand, fell through 2008 and have been flat since.  At the same time, builders have slowly reducing inventory.  So, part of the decline in new home sales reflects fewer new units for sale.

Finally, I note that real estate sales are far less sticky than real estate prices.  Declines in sales, especially declines of this magnitude, often precede declines in prices.  Maybe we haven’t seen the bottom of California’s real estate markets?

There is only one problem with DJ.  He doesn’t know squat about economics.  It’s not because I haven’t tried.  He refused to believe what I tried to share from my first economics class back in 69/70.  He’s refused to believe anything about economics that I’ve tried to teach him since.  DJ’s a communist, and he’s darn proud of it too, and he’s probably never going to learn, but I’m going to keep trying.

Which brings us to today’s topic.  DJ posted a link to this Robert Reich blog entry and a taunt on Facebook today.

In the blog, Reich correctly points out that inequality is a growing problem in America today.  Then, he starts getting things wrong, very wrong, basically coming to the conclusion that if we reduced managements’ incomes and increased workers’ incomes all would be well with the world.

I can’t believe that Reich really believes that if we just set a higher minimum wage and instituted a new maximum wage, we’d have prosperity for all.  It is well understood in economics that minimum wages increase unemployment and price ceilings create shortages.  Reich’s policy would cause output to fall, unemployment among lower-wage workers to dramatically increase, and management to move to someplace else, say Singapore or Hong Kong.

Inequality is problem, a serious problem and a growing problem.  The causes are a failed educational system, a completely inadequate safety net, and a lack of commitment to opportunity in far too many communities.

While returns to education have been increasing, our educational system has been declining.  The failure to prepare students for the workforce, particularly those who will not go to college, is paid for by the student.  It is paid for in lower income throughout their work life, and in more frequent and longer-lasting income interruptions.

Educational problems are not limited to k-12.  The rapid increase in the cost of a college degree is strong evidence that colleges and universities have managed to extract a significant portion of the gains to education, often leaving the student with debt that takes years to repay.  Too often that expensive, debt-funded, degree fails to provide the expected income, a result of a degree in a field with little market value or a program that lacked rigor.

The lack of an efficient safety net means that unemployed workers have an incentive to take the first available job offer.  That first job offer may be a perfect match, but it may not be.  The problem  is that without a safety net that would allow time for a search for a better match, or provide for geographic mobility, both  society and the worker are worse off.

Finally, communities limit opportunity in the service of quality of life, failing to recall that for many quality of life begins with opportunity.