Housing Policy, Monetary Policy, and the Great Recession

Here's a link to a research paper the Mercatus Center has published by me and Scott Sumner.

Housing Policy, Monetary Policy, and the Great Recession

It's a combination of Scott's work on Federal Reserve policy and my work on the housing bust.  Here is our takeaway:

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Policymakers should not slow the economy in an attempt to prevent bubbles, which are not easy to identify in real time. Such efforts to reduce demand in 2007–08 were not only unnecessary but were also responsible for the reces­sion and financial crisis. 

Instead, US policymakers should adopt regulatory, credit, and monetary policies that can help stabilize the econ­omy, allowing the creation of an environment for healthy growth in living standards. Such an approach involves three components:

1. Reform zoning regulations in urban areas. This would allow for more construction of new housing, espe­cially in closed-access cities such as Boston, Los Angeles, New York City, and San Francisco, where con­strained growth is currently resulting in high housing prices. The United States could sustainably employ many more workers in home construction if restrictions on building were removed. 
2. Avoid a situation where lending regulations are most lax during booms and tightest during recessions. It was this sort of regulatory pattern that almost certainly exacerbated the severity of the Great Recession. 
3. Monetary policy should seek stable growth in nominal gross domestic product (NGDP). Rather than target­ing inflation and unemployment, policymakers should aim for a relatively stable rate of growth in NGDP, the dollar value of all goods and services produced within a nation’s borders. Attempts to use monetary policy to pop bubbles in individual asset markets such as real estate often end up destabilizing the overall economy. A stable NGDP growth rate, however, will provide an environment that is conducive to a stable labor market and a stable financial system.

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If you're interested, at the link there is a link with a pdf download.  We address a wide range of evidence, some of which I am certain you have not seen before.

An article at Politico about letting banks help pump some cash into the pandemic scarred economy

Here is the Mercatus Center version:

https://www.mercatus.org/publications/covid-19/get-cash-more-families-need-it-now-give-banks-more-discretion-make-home-equity

Here is the Politico.com version:
https://www.politico.com/news/agenda/2020/03/21/how-mortgages-can-ease-the-downturn-140317

An excerpt:

Certainly, the 2008 financial crisis has created some reasonable fear about mortgage lending. But the dangers that were present in 2008 are not present today. There aren’t millions of recently purchased homes in cities where prices have suddenly doubled in a short period of time. Most borrowers will be long-time homeowners who braved the worst housing market in nearly a century and managed to hold on. In other words, unlike the housing bubble, these borrowers won’t be naïve new buyers speculating on a frenzied market; they will be established homeowners seeking financial safety during a pandemic. If ever there was a time to suspend the post-crisis regulatory framework, that time is now.

Yield Curve mid-September 2019 update

There has been quite a lot of movement in yields since last month, so I thought it would be useful to look at an update.

During the last half of June and July, the long end of the curve came down while the short end moved up a little bit.  I wish we had an NGDP futures market to check these intuitions against, but I think the best interpretation is that in June the Fed had reversed track a bit and signaled more dovish policy going forward, but then some compromises in that posture began to arise, so while they certainly are more dovish than they were several months ago, some of the optimism that was pressing long end rates higher in June has receded.

The slope of the curve from two years onward has remained relatively stable since then and the movements have mostly been movements in the estimated low point of yields in 2021.

At first glance, rising rates since the end of August are bullish.  But, that is entirely due to rising short term rates.  The long end has actually flattened slightly compared to the beginning of August (the blue line compared to the pink line).  There are obviously a mixture of factors here, and continued strength in the labor market is probably one reason for optimism.  But, it seems to me that the net movement of the past two weeks is probably bearish.  Less faith that a dovish commitment by the Fed will prevent a bit of a downturn.  That would lead me to suspect that the coming decline in the target short term rate will be somewhat tepid and will be associated with a sympathetic decline in the long end of the curve at first, back toward or below the levels of late August.

Market Concentration

John Cochrane discusses an interesting paper that claims that, while national concentration has increased, local concentration has decreased.  In other words, each location has more competition within various industries, but the competition is more among national chains than among local firms.  So, there top firms claim a larger portion of the national market, but at the local level, consumers have more choices.

What's going on? The natural implication is that the town once had 3 local restaurants, two local banks, and 3 stores. Now it has a McDonalds, a Burger King, a Denny's and an Applebees; a branch of Chase, B of A, and Wells Fargo, and a Walmart, Target, Best Buy, and Costco. National brands replace local stores, increasing the number of local stores.

Equity Values and Business Cycles

This chart is basically a "Financial Accounts of the US" version of the P/E ratio.  Also, here I show corporate debt as a ratio with corporate profit.

Source

These are as of the 3rd quarter of 2018.  After the recent pullback in equities, while earnings are strong, the P/E ratio (blue) is back to the teens.  And, corporate leverage is in a conservative range too.

Going forward it seems that there are two likely paths:

1) Stable NGDP growth leads to slightly lower profit growth, but higher wage growth and higher real total growth.

2) Unstable NGDP growth leads to lower profits and wages.

If (2) happens, equity losses will be widely blamed on valuations and debt even though they will more likely be caused by unstable NGDP growth.  In hindsight, it will always look like high valuations caused equity contractions and high debt levels, because equity prices will be lower and vulnerable firms will suddenly be too leveraged.  But cyclical contractions rarely have anything to do with valuations or corporate debt.

Housing: Part 339 - Self-Imposed Stagnation

Here is a graph comparing long term real GDP growth per capita and per worker.  Also, I show the 10 year trailing average annual real total return on the S&P500.

Real GDP per capita had been rising by about 2% for many years.  Real GDP per worker generally rises at about the same rate, but in the 1970s, it dipped down to less than 1%.  This is because the baby boomers were entering the workforce, so the labor force was increasing faster than population was, and we weren't getting as much productivity growth per worker as we had previously.  Some of this might just be a product of worker composition and young workers being less productive.  But, I think this shows why the 70s were a decade of economic insecurity even though it doesn't necessarily show up in real GDP growth or even real GDP growth per capita.

One plausible reason that equity risk premiums have been high recently and real bond yields low is that an aging population means that there are many households in the saving phase of their lives.  But, that doesn't explain the 1970s when real bond yields were also low.  In the 1970s, there was a surge of young adults.

Notice in this graph that total returns in equities seems to track pretty well with GDP growth per worker.  Since investor expectations can't be measured it has become widely accepted that even long term stock market movements are the product of fickle sentiment and that stock market returns are more volatile than changing economic growth rates because of that fickle sentiment.  Relationships like this suggest that sentiment isn't as fickle as it has been claimed to be.

There also seems to be a widely held belief that the US stock market is overvalued because of loose monetary policy.  To the extent that that sentiment affects public policy, and I think clearly it has, it is probably one reason why real growth has been so slow.  I'd like to stake out the principle that in order to propose the goal that the central bank should aim to lower real returns for existing shareholders, your model of how the world works should be at a level of confidence that is practically certain in a way that few economic models have ever been.

In my Upside Down CAPM model of thinking about capital markets, expected real total returns are fairly stable, at about 7% annually.  This is a combination of expected growth and current income.  When growth expectations decline, savers become risk averse.  So, two things happen to equity returns.  First, the equity risk premium (the difference between Treasury yields and equity returns) widens because safe-seeking investors are willing to accept lower returns while total expected returns on at-risk capital like equity remains relatively level.  Second, the growth portion of expected returns declines, which means that the income portion increases.

Recently and in the 70s and 80s, payout rates were high (dividends + buybacks) and in the 90s they were lower.  Generally, payouts are referred to as a bottom up phenomenon, as if firms can't find good investments, so they send the cash back to investors.  I think this is more appropriately viewed as a product of low growth, so that there may be some correlation between high payouts and low growth, but that it is more directly a product of low growth because equity investors require more cash flow in their total returns to make up for the lack of capital gains growth they expect.

The changes in real returns over time are related to the changes in GDP per worker, due to both the real shock of lower productivity and lower expectations that will naturally come along with that.  Those past equity investors, on the margin, expected returns of around 7% plus inflation, and where their realized returns differed from that, it was due to changing profits and changing expectations from those unforeseen changes in real production.

This is all a long-winded way of getting to the point I want to make, which is about the current decline in growth.  Here is a similar graph, but here I am comparing GDP growth per worker and per capita to the percentage of GDP going to residential investment, because that is the main reason for the recent decline.


Before the financial crisis, there was little relationship between Residential investment and GDP growth.  Some of the short-term growth in the 2000s before the crisis might have been related to it.  But, as I tend to point out, that was at least as much a product of building in the 1990s being below long term norms than it was a product of excessive building in the 2000s.  The low ten year moving average in 1999 was unprecedented in post-WW II data.  The high ten year average in 2007 was not.  So, maybe a lot of the rise in per capita GDP growth from just under 2% to somewhat above 2% was from homebuilding.  But it was homebuilding production that was reasonable and sustainable.

But, what I want to talk about is the post-crisis decline.  That decline can clearly largely be attributed to collapsing residential homebuilding.  GDP growth per capita declined from about 2% to about 1%, and residential investment declined by 2% of GDP.

I like Arnold Kling's conception of patterns of sustainable specialization and trade.  It is better to think of an economy as a coordination problem with frictions rather than as a set of accounting identities.  And, I think it would be uncontroversial in any audience to suggest that this is a large part of what happened after the crisis.  There were millions of construction affiliated workers after the crisis that faced frictions in finding work in a different sector.  Possibly, the recent uptick in per-worker GDP growth, the recent low levels of unemployment, and anecdotal claims that construction workers are hard to come by, are signs that those adjustments have finally been made.

My disagreement with the consensus on this is that none of that had to happen.  For the past decade, those workers should have been engaged in building homes, and GDP growth per capita should have been 2% instead of 1%.  Not only would that have meant that none of those painful adjustments needed to happen.  But, it also would have meant that we would have about $2 trillion worth of housing providing the service of shelter for American households.  And, the result would have been that American households would be shoveling a few hundred billion dollars less each year of unearned rental income to real estate owners.  (Of course, this is complicated by the fact that many of those real estate owners are homeowners, who can only capture that "income" by staying in a home that has inflated rental value, but a suppressed market price, so they can't actually realize the gains from their economic rents except by living in a home that has rental value higher than it should have to begin with.  But, this is getting too far down the rabbit hole.)

But, here we are, a decade later, and maybe most of those former construction workers have either moved to other sectors or just dropped permanently out of the labor force.  So, then, what do we do about the housing shortage?

Well, I have written some about the inequities in the way we have contracted the housing market, and I expect to write some more.  But, really, in the end, there is nothing unsustainable about this context.  We could have achieved similar ends by raising property taxes, or any number of things.  All consumption has some foundation of technological, tax, and regulatory factors that has an effect on supply and demand.  Just because our current context seems inequitable to me, that doesn't mean it can't exist as it is.  Non-owners will consume less housing, owners will consume more, and real estate investors will earn higher returns than I think they would in my preferred regime.  But, it's a sustainable regime.

So, the "economy" doesn't need housing to recover.  It could be that we now are at a new pattern of sustainable specialization and trade, and the new pattern just includes less consumption of shelter by the have-nots.  The workers that have been on the sidelines for a decade instead of building homes have slowly found other productive things to do.  So, fixing the housing shortage is more about equity than it is about growth.  It is possible that we have finally entered a new phase of growth, that ten years from now, GDP per worker will have risen by 20% and equity investors will have earned 12% annually plus inflation, that working class families will be moving to Sacramento by the thousands so that young entrepreneurs can rent their old studio apartments in San Francisco for $7,000 a month, and that marginal workers will still be paying $1,000 rent to live in homes in Cleveland that they could buy for $60,000 because we have decided as a public policy objective that it is too dangerous for them to have a mortgage.

Every line in those graphs could move back toward the top while the residential investment line stays at the bottom.  We would just live in an economy where some households don't consume housing like we did in the past, and real estate capital earns slightly higher returns.

PS: Since equities aren't as tied to domestic production as they used to be, it could be that the rate of real total return on equities will be less volatile going forward as a function of changing domestic productivity.  So, it could be that equity returns for the S&P 500 over the past ten years are higher than they would have been 40 years ago, given the same slow rate of GDP growth per worker, and that it won't rise as high as it used to with rising US productivity.

Housing: Part 333 - David Beckworth interviews Robert Kaplan

David Beckworth recently interviewed Robert Kaplan from the Dallas Federal Reserve Bank (transcript).  They discussed many interesting things regarding monetary policy.  There were a couple of items that I thought might be interesting to get into here.

Here is one spot:

Robert Kaplan: ...The nominal GDP targeting has a lot of appeal in that it takes into account inflation. It takes into account growth. The other thing is we are a very highly leveraged country. It's nominal GDP that services our debt.
David Beckworth: That's right.
Robert Kaplan: In other words, you need to generate nominal GDP to service the debt. There are some challenges though with this approach and others, which I actually would like to see us debate.
What's an example? How to explain nominal GDP targeting, in that there's a catch‑up mechanism in nominal GDP targeting and a lot of other aspects that I think are not going to be easy to communicate. The good news about the current framework is it's relatively straightforward to communicate.

This seems true, on the surface, but I think the more important point is that, in a way, NGDP targeting really wouldn't require communication.  How can I say that?  Well, what I'm thinking of is the countless conversations today about whether the Phillips Curve is useful, whether inflation trends will reverse or accelerate, whether expanding credit is feeding "overheating", etc.  Think of the millions of hours of debate and analysis that go into developing or forecasting Federal Reserve policy choices and their consequences.  The problem with the current dual mandate is that there is too much communication, and all the communication we could muster will never lead to consensus or certainty about near term economic activity.

With a functional nominal GDP targeting regime, there would be little to communicate.  And, what a relief that would be!

The following excerpt is more to the point of the focus of this blog - credit markets and the financial crisis.  As David points out, even this conversation would be less salient in an NGDP targeting world.  Management and regulation of credit markets wouldn't be so important if it wasn't an important ingredient in sudden negative NGDP shocks.  Kaplan's response to that notion is a window into the problem of seeing the housing bubble as a result of excess credit rather than a shortage of housing supply.

Robert Kaplan: If you look at the household sector in this country, the household sector was extremely leveraged. Meaning if you took household debt divided by gross domestic product for the households, there was a very high degree of leverage.
The reason we didn't notice it is if you looked at household debt relative to asset values, it actually didn't look excessive, back to home prices. What the housing crisis exposed is a lot of households were dramatically over‑leveraged, but they were comforted by the fact that there were easy mortgage conditions and home prices were very high.
Obviously, I don't need to remind people when the housing sector collapsed, all of a sudden, the household sector, it was clear, were very highly leveraged. They've spent the last eight or nine years deleveraging.
I think one of the lessons also, which relates to mortgage availability and so on, was we've got to watch the health of the household sector. Even with that, the aggressiveness on mortgage offerings were probably the tip of the iceberg.
It's all the securitizations upon securitizations upon securitizations of those mortgage obligations which magnified those excesses. If we didn't have all the securitizations on top of this aggressive mortgage lending, it still would have been painful, but it wouldn't have been anywhere near as painful as what ultimately happened.
David Beckworth: This goes back to the point you made earlier about nominal GDP targeting. Again, in a different world, a counterfactual world where we did have a nominal GDP level targeted, this would have made that crash a whole lot nicer or less severe.
Robert Kaplan: Truthfully, I wasn't at the Fed. I've been at the Fed only three years. I actually probably have a slightly different take. I think there's a number of things we do at the Fed. One of them is monetary policy, but another big one is macroprudential policy.
I think if you don't have good macroprudential policy, it's very difficult to run a sensible...It makes monetary policy harder. I think we need to do both. You could debate, and I've been part of those debates, to question monetary policy leading up to the crisis, approaches for monetary policy.
I think if you don't have good macroprudential policy for, again, stress testing, monitoring of the non‑bank financials, I think it makes it very hard to avoid instability.
David Beckworth: That's a fair point. If you did have those imbalances build up, let's say, for the sake of argument, you did have that leverage, I think the point you made earlier is that a nominal income target, a nominal GDP target that would make the unwinding of that leverage much more manageable. Is that fair?
Robert Kaplan: Listen, what I've learned is if the household sector gets over‑leveraged, you've got to accept it's going to take a number of years for households to deleverage. They're not like companies, who can sell assets, raise equity, restructure, restructure their debt. Households can't do that.
I think the trick is a little bit of prevention. I think we want to get into a situation where we monitor the household sector more carefully and try to take steps to maybe moderate excessive debt growth at the household sector relative to income. 

Kaplan's comments reflect what I think is considered an uncontroversial set of stipulations:

• Excessive credit led to home prices and household debt that were bloated.
• When home prices collapsed, households were left with the excessive debt.
• Deleveraging from that debt slowed down the recovery.

The solutions to these stipulated risks are:

• Prevent household debt from rising.
• Prevent excessive use of multi-level securitizations and financial derivatives.

First, I'll point out a bit of a contradiction here.  Multi-level securitizations and credit default swaps on those securitizations were developed in order to create securitizations that didn't require new mortgages.  High household debt and excessive complex securitizations and derivatives are substitutes, not complements.  They didn't additively lead to a more acute crisis.  In fact, the rise of complex securitizations and mortgage-based derivatives came from having more savers looking for safe assets than there were investors taking the primary risk positions on either securitizations or home equity, itself.  The reason complex securitizations were profitable for their underwriters was because investors were willing to pay a premium for securities with lower expected risk.

I have discussed this many times, so I won't go into it here again in more detail, but this is an important, if subtle, correction to the credit-fueled bubble narrative.  Synthetic CDOs, CDO-squareds, etc. were the first stage of the bust, and they came about because the core cause of the bubble was a lack of housing supply, but the bubble was addressed as if it was due to a lack of fear.  Investors in the CDO AAA-securities were risk-averse.

Regarding the other points, what if high home prices are generally due to an urban supply shortage, and rising mortgage levels are a side-effect of that problem?  Then, what will happen as a result of the proposed solutions?

• Home prices will remain somewhat elevated because of high rents.
• Since credit is a side effect of high prices, there will be natural pressures pushing up demand for household debt.
• To reduce that demand for household debt, taxes or non-price constraints will need to be implemented to reduce the quantity of household debt.
• In order to keep household debt at a normal level as a percentage of income, debt will have to be held low as a percentage of home values and/or homeownership will have to be lowered.
• Regulatory obstacles to home ownership will raise the yield on home equity - to some extent through lower prices and to some extent through higher rents.

So, the policy that seems like the prudent policy for the Federal Reserve to follow is a policy that will create high yields for a set of households who meet regulatory approval and that will create high costs for households who do not meet regulatory approval.  Over the past several years, this has been the case.  Using BEA data on housing value added and Fed data on mortgage and real estate values, the past few years have been unique in providing real returns on home equity that are higher than nominal yields on mortgages outstanding.

And, it is highly likely that regulatory approval will fall sharply along socio-economic status lines.

I am not arguing here that high debt levels are not systemically destabilizing.  I am not arguing that we shouldn't be concerned about them.  I am simply pointing out that the only realistic way to enforce this macroprudential policy is to enforce higher-than-market returns for select Americans while limiting access to those returns.  To be honest about that means being clear-eyed about the cause of high levels of household debt.

Or, to put this another way, there are many sources of value in an economy.  A marketable college degree creates value, in the form of human capital, but it is difficult to have liquid markets in human capital.  So, there isn't a ZillowPeople.com where you can see the current market value of college graduates and their current market wage.

Yet, in a way, housing sort of serves as a substitute for the market in human capital.  If a banker feels confident enough in your earning ability, she will allow you to take out a mortgage to commit to transferring some of the high wages you can earn to future payments.  The potential to foreclose on the house serves as a financial tool that facilitates this trade in human capital.  The banker serves as an intermediary, using the liquidity of the mortgage market and the stability of the housing market to facilitate trading activity in the human capital market.

That is what was happening before the crisis.  In most places, the mortgage and housing markets have developed to the point that more than 80% of households can complete that trade at some point in their lives.  This is a testament to the development of human capital (broad access to above-subsistence wages) and of real estate and mortgage markets.  But, our economy was hamstrung by a political limit to urbanization, which created a dichotomy: places that were exclusive and places that weren't.

That exclusivity is rationed through housing, and by happenstance there is a liquid market that measures the value of that exclusion.  There is a Zillow.com for houses.  Before the crisis, this trade in human capital and housing was still functioning, but in the Closed Access cities, this meant that only those with a large excess of human capital could engage in that trade.  They had to transfer a large stake in their future earnings over to the existing real estate owners to claim their place in exclusive labor markets.  In order to fully accrue the full potential of their human capital, they had to pay the toll to access the markets where wages were highest.

Home prices reflected the value of that exclusion, and homes traded at a value at reflected their claim on that earning power.  Certainly, the existence of these credit markets facilitated the market that revealed those values.

By focusing on credit as the cause of high prices, these transactions between human capital and the housing stock have been hobbled.  The undiscounted total value of future rents on properties has not been reduced.  "Macroprudential" management on mortgage markets has just added a significant premium to the discount rate that is applied to those future rental incomes.  This has lowered home prices in Closed Access markets from where they would have been, and it certainly has reduced household debt from where it would be in this Closed Access context.  But, because this is a misdiagnosis of the problem, where its effect has been the worst has been to block access to low tier housing markets in cities across the country that were never out of whack.  (I touched on this in the previous post.)

Macroprudential management has effectively been a step backwards to a less sophisticated economy, where access to ownership of real property requires a pre-existing stockpile of wealth, and those who have wealth earn higher returns on it.

Housing: Part 332 - The problem in a picture

I came upon some old data recently that I thought was worth sharing.  Sorry, this isn't updated past 2014 data, but the story hasn't changed that much since then.  Maybe real estate values have recovered another 10% or so, compared to personal income.

Here is the problem.  There are two housing markets in the US.  A closed one and an open one.  The closed market gives you access to the best economic opportunities in NYC, LA, Boston, and San Francisco (Closed Access cities).  It's limited to about 50 million people.  You want in, you gotta pay.

Sources: BEA and Zillow

Here is a graph of total real estate value as a percentage of total personal income.  In 1998, in the Closed Access cities and in the rest of the country, the ratio was about 2:1.

Then, as we entered the post-industrial economic era, competition for access to the Closed Access cities pushed real estate there up to close to 350% of income.  In the rest of the country (which includes the Contagion cities, Seattle, Washington, etc.), it didn't break 250%.  Even that increase can be effectively explained with low long term real interest rates.

By 2014, in the Closed Access cities, it was 248%, while the rest of the country was down to 166%.  Now, this is with very low long term real interest rates, so, if anything, it should be above 250% even outside the Closed Access cities.

Keep this in mind when you read countless articles complaining about affordability.  Homes are more affordable than ever, really, for owners.  It's just that some homes have a premium attached to them that is unrelated to the value of shelter.  Imagine how backwards economic and monetary policy is right now, that it is not unusual to hear people call for or accept contractionary monetary or fiscal policy because home prices are getting too high again, and macroprudential policy is called for.

Also, consider the countless articles and conversations that complain about how we bailed out the banks but left regular households hung out to dry.  You know what really killed those households?  Maybe it was the fact that they lost wealth, on average, that amounted to nearly a year's income.  When real estate value outside the Closed Access cities collapsed from 236% or incomes in 2006 to 157% in 2012, how many of these moral crusaders were demanding more monetary support because home values had clearly fallen too low?

Don't get me wrong.  It isn't the job of the Fed or the government to prop up home prices.  But, it is their job to allow markets to function.  The "bailouts" were only a very poor substitute for reasonable federal macroprudential and monetary policy.  But, any reasonable policy would not have led to such drops in real estate values, especially after 2007.  How many bailout critics would have supported those policies?  That would have created moral hazard.  Right?  Because everyone knew that homes were too expensive.

One more thing about that graph.  It shows less recovery than some other measures of price/income do.  I think the main reason is that normally, price/income is based on the price of the median home compared to the median income.  Since we have been in a decade-long housing depression, the aggregate value of real estate has risen less than the value of individual properties.  This is an important part of what is happening, but it is difficult to understand it with "bubble" thinking.  Bubble thinking presumes that more building is triggered by money and credit, so that more building equals rising values.  That has it backwards.  The red line rose much higher than the blue line precisely because that relationship is very strongly in the opposite direction.

Closed Access real estate rose in value so much because there are not as many new Closed Access homes.  And, even on a national level over time, aggregate real estate value has little to do with the rate of building.  The reason that real estate value has declined along with lower rates of building since 2007 is that credit and monetary policy pushed home values well below the value that could trigger new building in many markets.  The decline in value led to lower rates of building, not the other way around.

The way to reduce things like median price/income levels so that homes become affordable again is to build many, many new homes.  That will have very little effect on the aggregate value of real estate.  In fact, if we do it well enough, it will reduce the aggregate value of real estate.  But, it will be hard to trigger new supply until credit is loosened enough and prices rise enough that more new construction can be justified.

There seem to be many macroeconomic issues that have this strange, contradictory type of causation.  In this case, rising prices cause more building, but more building causes declining prices.  Clearly, more building could cause prices to decline so sharply that more building would cause total value to decline, even after adding new real supply to the housing stock.

Housing prices need to rise so housing prices can fall.

Housing: Part 324 - Commercial Real Estate, Dean Baker, etc.

Arnold Kling points to this post by Dean Baker.  The last paragraph of the Baker post gives Baker's basic conclusion:

The basic story is that demand plummeted first and foremost because of the collapse of the housing bubble, along with the collapse of the bubble in non-residential construction that arose as the housing bubble began to deflate. The financial crisis undoubtedly hastened these collapses, but a steep drop in demand was made inevitable by these unsustainable bubbles that had been driving the recovery from the 2001 recession.

He is arguing against Bernanke's recent posts where Bernanke claims the recession was deepened more by the financial panics than by the housing bust.  (I basically agree with Bernanke, and I would say that the panics were largely caused by Fed policy choices in 2006-2008, and the losses were made permanent/justified by the extremely tight lending standards imposed by the post-conservatorship GSEs and CFPB.)

Bernanke points to the post-crisis drop in non-residential investment as evidence of the importance of the financial crisis in creating the deep recession.  Baker counters that the drop in non-residential investment was mostly a drop in non-residential construction, and was simply a part of the same bubble that had infected residential building.

I'm not sure if I have that much new to add here.  The entire thing pivots basically on this comment by Baker: "Again, the collapse of Lehman hastened this decline, but the end of this bubble was inevitable."  Whether the bust was truly inevitable or not is beside the point.  The bust was inevitable because the zeitgeist had deemed it inevitable.  The conclusions are a product of the presumptions.

And, looking at the CEPR paper that forms the basis of Baker's post, we can see the source of the false presumptions.  In the bullet points that summarize the paper, he notes, among other things:

The decline in residential construction during the downturn was mostly just a return to trend levels of construction, along with a predictable reduction due to the overbuilding of the bubble years. Any impact of the financial crisis was very much secondary.

 ….

The bubble and the risks it posed should have been evident to any careful observer. We saw an unprecedented run-up in house prices with no plausible explanation in the fundamentals of the housing market. Rents largely rose in step with inflation, which was inconsistent with house prices being driven by a shortage of housing.

Unfortunately, these assertions are broadly accepted as canon.  Obviously, taking opposition to the overbuilding issue is central to my work.  In the paper, Baker includes figures for residential construction as a % of GDP, which begins at 1980, and for non-residential construction as a % of GDP, which begins at 2002.  Here is a graph of those two measures, dating to 1960.

I agree with Kling that Baker seems to be an independent thinker. But his choice of start dates seem especially useful for magnifying the level of these measures during the "bubble" years.  I don't think he is trying to be misleading.  The bubble is canonized and setting the timeframe to maximize the apparent excess is part of the public hypnosis in support of the false canon.

In addition to the long-term view, there are a couple of points that might be made about these measures, which it is possible that Baker missed.  Within the non-residential category, "mining exploration, shafts, and wells" increased from 0.3% to 0.9% of GDP from 2003 to the end 2008.

Also the residential category includes brokers commissions on real estate transactions.  From 2000 to 2005, that increased from 0.9% to 1.4% of GDP.  If you subtract that from the residential investment measure, the peak level is at about the same % of GDP as the peaks in the 1970s.  Brokers commissions have nothing to do with building.  In fact, they were bloated specifically because of under-building.  They were bloated because of existing homes in coastal California selling for a million dollars.

But, nonetheless, building was strong at the same time prices were rising, which brings us to the second canonized false presumption that Baker references above: the idea that rising prices were unrelated to rising rent.  This is, again, a product of the public hypnosis on this issue.  Even looking nationally, rent inflation had been above non-rent core CPI inflation for the entire period from 1995 to 2008 - far above non-rent inflation for much of that time.  From the end of 1994 to Sept. 2008, non-shelter core CPI averaged 1.8% and shelter CPI averaged 3%.  But, the problem is even worse when you look at the MSA level instead of the national level.  Generally where prices increased, rents had increased.  So, it's more like there were many places with moderate prices and normal rent inflation and places with high prices and rent inflation persistently well above general inflation.  And, those were places that definitely were not over-investing in construction.  At the MSA level rent explains almost everything.  And, on this point, the public hypnosis is striking.  Open coastal urban newspapers or twitter and the topic is high rents in the coastal metropolises.  It isn't as if this is a secret.  But, hypnosis is strong enough to create mental silos on this issue.

This is part of the story on rising prices.  Before the mid-1990s, if rent affordability got worse in a city, it tended to revert to the mean.  But, beginning in the 1990s, the economy became characterized by this new regime, where urbanization has new value, the urban centers that would create that value do not grow, and workers must segregate by skill and income into and out of those cities.  So, now migration patterns exacerbate the rent inflation problem rather than causing rents and incomes to revert to the national mean.  Prices in 2005 reflected this regime shift.

But, the bubble was canonized before this realization was made.  One might argue that rents should still revert to the mean and that bubble prices still reflected over-optimism, even if rents had been rising for a decade.  (That would be wrong, as rent inflation has resumed after the crisis, but at least it would be an argument that addressed the facts.)  Instead, a false reality is invoked, rent inflation is ignored, and discussions of housing market sentiment revolve largely around price expectations, which, by presumption, leads to behavioral explanations.  Again, I don't say this to be harsh regarding Baker.  To treat rent correctly would be a radical, contrarian position.  Until this correction gets made in the zeitgeist, you might as well complain that he references gravity without engaging in an experimental proof.  It's canon, and the canon is wrong.

Regarding prices, here is a graph of various property types.

The thick orange line is non-residential commercial real estate.  The thick blue line is residential commercial real estate (multi-family buildings).  These are from CoStar.

Figure 5 in Baker's CEPR paper, published in September 2018, shows commercial real estate prices from 2002 to 2010 in order to show how strong the bubble was in commercial building.  He writes:

The plunge following the collapse of Lehman is not a surprise. Non-residential construction is largely dependent on bank credit, and when this dried up with the financial crisis, it was inevitable that it would take a serious hit. But the financial crisis was only the proximate cause of the drop in non-residential construction. The bursting of the bubble was inevitable in any case, the only question was the timing and specific events that set it in motion.

I do not disagree about the importance of credit.  This is all about presumptions.  This entire discussion hinges on one word: "inevitable".

A diversified basket of multi-family real estate bought at the peak of the "bubble" at the end of 2006 would have returned 44% of capital gains in addition to rental income over the following 12 years.  In the 9 years since the nadir at the end of 2009, it would have returned 124%.

In the graph above, I have also included the national Case-Shiller home price index (black), price levels from Zillow for the top and bottom of the Atlanta market (gray) and the LA market (red/orange).  Maybe I am confusing matters by including LA.  Many will see the clear signs of a credit-fueled bubble in the low tier prices in LA, but the truth of the matter is too complicated to go into here.  But, these measures tell a more complete story about what happened.

Once we recognize that rising rents are the main difference between LA and Atlanta and that credit at the extensive margin was not an important factor in the boom (which is clear in Atlanta and most other cities where price appreciation was not very different between top and bottom tier homes during the boom), we can see a different story.

Remove "inevitable" from your presumptions.  The consensus around "inevitable" led to acceptance of, even demands for, a negative credit shock in owner-occupier housing markets that continues to this day.  Nothing was inevitable.  Residential housing markets look like they track along with commercial markets for the entire period.  But, they are a chimera.  They contain open markets and closed markets.  Before 2007, prices in most markets, like Atlanta, were benign, and prices were very high in housing constrained markets.  Sentiment and credit access began to turn in a series of trend shifts and events from the end of 2005 to 2008.  Housing starts started to collapse in 2006 and prices eventually fell sharply after mid-2007.  This happened in Atlanta and LA and everywhere in between.  Since intrinsic value remained strong, commercial building, even in residential, remained strong until 2008, and rent inflation across the country spiked in 2006 and 2007 as new single family supply dried up.

Then, we imposed the "inevitable" bust on the owner-occupier housing market.  Instead of looking for ways to stabilize mortgage markets, lending was largely cut off to the bottom half of the market from 2008 on, and we can see the devastating effect if we look within cities, most of which look like Atlanta, where low tier prices took a post-crisis hit to valuations, frequently of 30% or more.  This has caused the market price of low tier homes to drop below the cost of construction, causing new building to dry up in low tier housing markets.  The lack of supply in those markets has been a boon to commercial residential builders, who have access to equity and borrowed capital.  Ample building is happening there, but it can't make up for the tremendous hit that owner-occupied single family homes have taken, and it can't create ample coastal urban supply.  So, the boon to multi-family builders continues for the same reason prices were high in 2005: there aren't enough units, especially where demand is greatest.

The national multi-family market reflects a price level that is not credit constrained, but is supply constrained.  The national home price reflects a price level that is credit constrained, which is a mixture of cities like LA, which is supply constrained, and Atlanta, which is especially credit constrained, and is only supply constrained now because it is credit constrained.

New podcast out on my housing research

Here I am talking with David Beckworth about my housing research.

https://soundcloud.com/macro-musings/kevinerdmann

Housing: Part 312 - An introductory slide deck to my new view of the housing boom and financial crisis

Here is a slide deck introducing my work on the housing bubble and the financial crisis.  I will keep a version of this in the page links in the right margin, for future reference.

Housing: Part 303 - The Fed Balance Sheet

Scott Sumner shared my recent Mercatus papers over at EconLog.  Scott generously supports much of my push-back against the bubble story.  Economist Bob Murphy saw the post and reacted with some chagrin that Scott or I could question the idea that the pre-crisis housing market should be broadly characterized as a bubble, or that the crisis could be blamed on tight monetary policy.

Source

In support of his chagrin, he uses the measure of the Federal Reserve's balance sheet (the blue line in this graph).  The Fed balance sheet shot up in late September and October of 2008, and then continued to grow with the QEs.

I have probably gone over all of this before, in some form, but this seemed like a good excuse to look at it again.  First, it is worth taking a closer look at this graph.  Here is a close-up look at the Fed balance sheet in 2008 along with the Fed Funds Rate.

Source

By mid-November, the Fed had added more than $1 trillion to its balance sheet.  Half of that rise came in September and October when the Fed Funds Rate was sitting at 2%.  Even Ben Bernanke admits that holding the rate at 2%was a mistake.  The initial burst in the Fed balance sheet was due to interest on reserves, which the Fed began to pay because the 2% target rate was so far above neutral at that point that they would have had to sell every single Treasury they had in order to hit their target.  As crazy as this sounds, this was the actual reason for the policy (see here and Bernanke's memoir).

Most of the rest of the increase came when the target rate was still at 1.5%, and the target rate was still at 1% when the balance sheet topped out.  Until QE3, most of the increase in the Fed balance sheet dates to this period that was before QE and was even before the Fed Funds rate hit the zero lower bound.  Heck, half of it happened while the Fed was maddeningly trying to keep the Fed Funds rate at 2%.  They couldn't keep the rate at 2% because they had induced a financial panic, so interest on reserves was intended to force a rate floor by sucking funds out of the banks.  So the initial increase in the Fed balance sheet has nothing to do with loose monetary policy.  It seems as though many people who use the monetary base as a measure of monetary policy haven't accounted for this at all.

QE1 really didn't add much to the balance sheet.  It was mostly swapping Treasuries and MBSs for emergency loans to banks.  The short hand that I use for what happened is that the Fed had policy so tight it was running out of ways to suck cash out of the economy, so instead it started sucking credit out of the economy by offering to borrow cash from the banks and then stick it in a vault so it couldn't be used (excess reserves).  And, looking back at the first graph, we can see that happening.  From September 2008 to the end of QE1, bank lending dropped way off while deposits continued to grow at somewhat normal rates.  So, the gap in bank lending roughly equals the amount of excess reserves.  The banks "loaned" cash to the Fed so that it could hoard the cash and do nothing with it instead of loaning it into the private economy.

Clearly the growth of the Fed balance sheet ceased to be a good measure of monetary accommodation at this point.

Considering conditions today, it seems as though what we should see happen as the Fed reduces its asset base is that bank lending should re-converge with the level of deposits.  There is a bit of a delicate balance here for the Fed, because if they reduce the balance sheet size too fast with monetary policy that is otherwise too tight, the net effect will be for that convergence to happen through declining deposits.  If they reduce the size of the balance sheet while being too accommodative (for instance, this might policy happen if they stopped paying interest on reserves and returned the Fed Funds Rate back to zero, though even then I'm not sure the net effect would be accommodative if it coincided with a reduction in the balance sheet) then possibly banks would lend at such a pace that deposits would start to grow more quickly.

Source

Unfortunately, it appears that they may be erring on the side of reducing the balance sheet while maintaining policy that is too tight.  Here are the 1 year rates of change in deposits and bank lending.  Both are growing at less than 5% and are decelerating.  Lending had looked like it was stabilizing, but over the past 4 weeks, levels of Commercial and Industrial Loans and Closed End Residential Real Estate loans have both declined.

But, the more important story here is that clearly the monetary base is not a good measure of monetary policy under the current regime, and certainly it wasn't in 2008.

Housing: Part 300 - The Global Bubble Hypnosis is a Larger Problem than NIMBYs

Here is a recent article at the Financial Times.  The headline:

New York property jitters herald declines elsewhere

 The first line:

Clouds are hovering over New York’s housing market.

This is a great example of the mass hypnosis that has infected the public consensus on housing.

There is a broadening realization that the lack of access to urban labor markets and the lack of access to affordable urban housing are the prime challenge of early 21st century economics.  The problem is, solving that problem requires economic dislocation and upheaval of urban housing markets.  If you see falling real estate prices in urban centers should your reaction be to worry about "clouds hovering" over urban real estate markets?  I say, celebrate.

If our primary economic problem is that a lack of housing in urban centers causes it to be overpriced by a factor of 2 or more, then the DIRECT solution to that problem is that urban real estate needs to lose 50% or more of its value.  This article begins by noting that the median price per square foot in New York City has declined by 18% from last year.  Your reaction to that should be, "That's a great start!"  Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

Further, the article argues that global capital markets are leading to a new synchronization of urban real estate markets, so that additional supply is such a strong factor in bringing down urban housing costs that new units in New York City can bring down prices in London.  Your reaction to that should be, "Wonderful news!  Supply is a much more powerful factor than we thought."  Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

Reasons given in the article for this drop in New York prices include: (1) removal of tax benefits, (2) "glut" of luxury supply, (3) globalization, (4) "financialization", (5) "ultra-loose" money.  Your reaction to that should be, "Oh.  OK.  Those must all be good things.  Let's do more of those things."   Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

But, that's not the direction the article takes.  The article notes that sales volume is also down, and, as is the convention, it treats this downturn as the inevitable end of a boom bust cycle.  So, instead of seeing the drop in sales as a sign that all these good things might come to an end - as something we should counter - the article treats the boom that preceded it as the problem, and the solutions proposed are all policies aimed at stopping the real estate expansion before it develops!

This is an explicit defense of a monetary and credit regime that is specified to ensure rising urban real estate costs.

Now, admittedly the problem of solving urban costs is difficult, because normalized, unconstrained urban housing markets would require building with few unnecessary obstructions and low costs.  And, part of what happens in these regimes is that the bridge between basic costs and market value gets filled with all sorts of "limited access" rent seeking.  Developer fees, concessions to advocacy and neighborhood groups and municipal powers, queuing, etc.  These added costs emerged.  They didn't develop as some sort of plan.  So, if supply actually starts to increase enough to bring rents down to a reasonable level, these extra costs will have to be reduced in order to allow new development to come online profitably. Since the cost of queuing is pure waste, the first step here is "easy".  Just keep pushing through more projects for approval that are bringing in those "clouds".  There are a few trillion reasons why local planning boards aren't going to do that to existing owners and developers.

But, for activists and researchers who want to solve the urban housing problem and for global financial journalists who cover these markets, the reaction to that political problem should not be to kill any booms in their infancy.  The reaction should be, "How do we entice these urban planning departments to keep pushing through new supply when it looks like a downturn is coming?"  Because, to refer to any supply in these cities as anywhere close to a "glut" is a laugh.  A horrible, dark, depressing laugh.  There will be a glut of supply when rent in New York City is similar to rent in Atlanta, or even Chicago.  Until then, any use of the word "glut" to describe New York City housing should be met with laughter.

The reason we are engaged in this odd public rhetorical house of mirrors is because we all have a virus in our brain.  It's a cultural meme.  And it's a received canonical premise that there was a housing bubble, and that bubble was caused by loose money and loose credit.

The housing bubble, such that it was, was caused by an extreme shortage of urban supply.  Because of that shortage of supply, the process of meeting the public need for housing requires a "bubble" and the availability of credit that is flexible enough to allow for ownership where rents regularly take 50% or more of a household's budget.  Since supply in those cities barely responds to price, prices in those cities have to be bid up to high enough levels to induce outmigration so that new housing can be built in the rest of the country where supply can react to high prices and high demand.  At the peak of the US housing "bubble", credit markets were just beginning to push market prices to a level that induced that new supply.

Now, it would be better to build ample units in the urban centers.  But, since that doesn't appear to be close to happening, this was a second-best solution.  And, in terms of rent - which is the appropriate measure for considering housing affordability - 2005, briefly, was the one point since 1995 where supply at the national level was abundant enough to moderate rising rents.

Unfortunately, the Closed Access cities in the US are such a problem that in order to create enough housing at the national level, we had to induce a mass migration event out of those cities, and that mass migration event was the source of the dislocations in places like Phoenix that drove the country to demand a credit and monetary contraction.

This is the first step to fixing the problem.  We need to get that virus out of our heads.  The problem, all along, was supply.  Trying to pop the bubble before it inflates is the opposite of what we need to do.  I think the first rhetorical step to beat this virus is to stop thinking about housing affordability and housing markets in terms of price.  Price is a secondary function.  Affordability is about rent.  And, in the end, price is also about rent.  And, in the past 25 years, there have been two successful means for moderating rents.  (1) build like it's 2005, or (2) pull back on the money supply and credit so severely that a good portion of the country is foreclosed upon.

If we had committed to (1), today rents would be lower, prices would be higher, homeownership would be strong, and American balance sheets would be healthy.  It would be nice if a lot more of those American households could also live in the coastal cities.  I don't know if that can happen, but it sure as heck isn't going to happen if there is a consensus reaction to protect those precious urban real estate values every time the solution actually starts to play out by worrying about a "glut" of supply, and then by accepting pro-cyclical credit and monetary policies in order to "pop" the "bubble".

In that counterfactual, where the urban supply problem isn't solved and the rest of us commit to abundant supply, there would be gnashing of teeth about how the Federal Reserve is feeding bubbles and they are at fault for making home prices too high.  We have indulged that intuition for a decade now.  Now we know how wrong that is.  This was the darkest timeline.  Let's roll the dice again and proceed with the knowledge that doing it wrong has provided us.

New York real estate is getting cheaper and is pulling housing costs down in other cities, says the Financial Times, because (1) removal of tax benefits, (2) "glut" of luxury supply, (3) globalization, (4) "financialization", (5) "ultra-loose" money.  OK.  Those must all be good things.  Let's do more of those things.  What's your purpose?

Housing: Part 297 - A Review of the Soon-To-Be New View on Housing

As I prepare parts of this project for wider dissemination later this year, it is nice to see several schools of thought which inform this new view gaining favor. My project is the puzzle piece that solves some of the remaining mysteries and pulls these schools of thought into a coherent whole.

There are three movements or focal points of research that have become building blocks for this new view:

• Market Monetarism:  This is a school of thought based on the idea that central banks should focus on stabilizing nominal incomes rather than focusing on inflation and unemployment. This seems to be gaining momentum, and it seems like it would lead to better central bank policy outcomes. The important point for my project is that, since market monetarists tend to measure de facto central bank outcomes with nominal income growth, they tend to conclude that the financial crisis was created by tight monetary policy in 2008, the crisis was not inevitable, and there was no direct, inevitable link between the housing bust that had been building in 2006 and 2007 and the recession in 2008 and 2009.

• The Passive Credit School: Researchers like Demyanyk or Adelino, Schoar, & Severino, or Albanesi, De Giorgi, & Nosal, or Foote, Loewenstein, & Willen have been building a set of research that questions some of the presumptions of the popular accounts of the housing bubble. Borrowers during the boom didn't have particularly low incomes, low credit scores, or less education than usual, the crisis wasn't triggered by defaults that followed rate resets (as many had predicted), systemically destabilizing mortgage products were mostly being used by sophisticated borrowers who defaulted because home prices collapsed rather than because of affordability problems. Etc.

• The New Urbanization:  Richard Florida has been describing this phenomenon for years. Hsieh & Moretti have done some interesting work. I would put the work of Autor, Dorn, & Hanson in this category. The YIMBY movement is building steam. Even though many urban housing activists tend to seek regulatory solutions rather than focusing on supply, there is a budding consensus that a lack of affordable urban housing is a really big problem

There are several blind spots and false premises which keep these movements from seeing that an endemic shortage of urban housing is the connective tissue that binds them all together.
The broad consensus that the housing boom was, fundamentally, a credit bubble prevents market monetarists from taking the leap to realizing that even the housing crisis was caused by destabilizing tight monetary and credit policies, which date back to as early as 2006 and continue in many ways to today. It's hard enough to try to claim that the housing bubble and bust didn't cause the recession. It would be crazy to try to argue that a recession caused the housing bust, but that is essentially what happened.

That broad consensus also prevents the passive credit school from pushing to a strong conclusion, because since they still tend to believe what happened can be described as a bubble, that there has to be some ad hoc explanation for why a bubble developed. This increases the confidence that the credit supply school has in the competing theory that unsustainable credit supply was the causal factor in the housing bubble and bust. The passive credit school would be on much firmer ground to conclude that there was no (or only an isolated) housing bubble. But, they cannot reach that conclusion based on currently accepted presumptions.

The new urban movement also is limited by the consensus presumptions about the housing boom. If your motivating principle is that we need more housing, it's a pretty big obstacle to have this idea that only a dozen years ago our big problem was that we had too much housing. So, again, their voices are weakened whenever policies that would solve the problem would seem, as a first order effect, to increase lending, home prices, or building development. All of their work is much more coherent once that false presumption is removed.

New evidence, which help to see that the consensus presumptions are wrong, include:

• The flight from homeownership, and from living in the urban centers with constrained housing markets developed before the most aggressive price inflation happened, before the private securitization markets boomed, well before the CDO market that started the series of financial panics.  First time home buyers were declining as a portion of all households by 2005.  The private securitization boom was not associated with any increase in lending to first time buyers.
• The peak bubble period was associated with a massive migration event from cities with high home prices to cities with lower home prices.
• Taking all types of units into account, there was never an oversupply of housing in any city with a strong housing market. The rise in construction employment was not unsustainable.
• The cities where low tier home prices rose more sharply than prices in high tier markets were an anomaly, and the source of that price differential was not credit supply.
• The anomalous collapse in low tier home prices was universal across cities, and it happened after late 2008. It was not due to a supply overhang or to a lack of qualified borrowers. It was due to the regulatory imposition of extremely tight lending standards through the federally controlled GSEs and standards set by Dodd-Frank.
• The time after the extreme tightening in credit standards is the time when the US market deviates from international comparisons. US-specific monetary and credit policies aren't likely explanations of boom period home prices because boom period prices followed international patterns.
• The primary factor influencing home prices during the boom was location, and when comparing locations, changing rent levels explains nearly all rising prices.

In sum, rising prices during the boom were due to deprivation of supply, not excess credit and money. Once this realization is allowed to inform our presumptions about the market, the importance of the three schools of thought above, and the over-riding problem that connects them - an endemic shortage of housing - becomes clear.

Increased housing supply is what would have fixed the housing bubble. The myth that there was an oversupply overwhelmed our collective sense about what was happening. The Fed was never too accommodative. Home buyers, for the most part, were never too optimistic or speculative. There were never too many homes.

Once those conditions are accepted, the bold conclusions that the three movements above should lead to become obvious, and those seemingly unrelated movements reinforce each other.

Housing: Part 296 - Presumed bubbles are self-fulfilling prophecies

I recently saw this tweet by John Taylor, and for a moment, I thought, "Oh, no.  I've been scooped."

In an interesting 10-year anniversary article, @PIrelandatBC and Darko Oračić argue that the Great Recession "was not the inevitable consequence of unstable asset markets but followed, instead, from a series of unfortunate government policy mistakes." https://t.co/lCImVS0VkQ

— John B. Taylor (@EconomicsOne) May 12, 2018

But, alas, would that it were so.  The article does get something right: "the Great Recession was not the inevitable consequence of unstable asset markets but followed, instead, from a series of unfortunate government policy mistakes."

But, of course, the first mistake they identify is that the Fed caused the housing bubble through loose monetary policy.  Now, one problem with this, as the authors point out, is:

Some economists question this interpretation of the data, arguing that the short-term interest rates under the Fed’s control have little connection to the longer-term mortgages that finance the purchase of new homes.  A 2010 New York Fed working paper, however, explains that banks and other mortgage providers borrow funds on a short-term basis to make longer-term loans.  Their activities open a channel through which policy-induced movements in short-term rates strongly affect the profitability of lending and thereby affect the mortgage and housing markets.

This leads to another problem, because the Fed was raising rates in 2004 and 2005 when the housing bubble peaked.  In order to solve this problem, the authors lag short term interest rates.  So, for instance, in a graph of home price changes compared to the Fed Funds rate, they lag the Fed Funds rate by two years.  So, the low Fed Funds rate in 2003 correlates with home prices in Phoenix in 2005 rising by 40%.

I can sort of meet the authors halfway here.  This is probably the most striking event that is visible in the moving chart I posted here.  Some combination of flexible mortgage credit markets, accommodative monetary policy, and real economic growth, fed a boom in Los Angeles housing markets in 2003 and early 2004.  Then, watching this in time-lapse, we can see that very soon after the Fed began raising rates in 2004, there was a sharp downshift in Los Angeles housing markets and a very sharp upshift in the Phoenix market.  This coincided with a massive migration event into Phoenix.



You can really see in this moving chart how the Phoenix and Los Angeles markets became tethered to a single extreme causal thread.  So, maybe some of that LA boom in 2003 was related to monetary policy.  And, maybe the pressure on the LA housing market that grew out of that boom was related to the 2005 Phoenix bubble.  But the factor that pulls those markets together isn't that there was an oversupply of housing or an unsustainable pop in real residential investment.  The cause was that there can't be a sustainable growth in Los Angeles residential investment.

The bubble in 2005, as is strikingly clear in this moving chart, was caused by a massive movement down-market from expensive LA homes to less expensive Phoenix homes.  By the end of 2005, the Fed had tightened enough that the entire national market drops together like a bag of bricks.  Watching this chart move, you really can almost feel your stomache rise at the beginning of 2006 like you're on a roller coaster drop.  So, to the extent that accommodative monetary policy in 2003 was a factor in rising prices in 2005, the rising rates in 2004 were a factor in the drop that began in 2006.

So, if monetary policy works with a two year lag, then it was too tight by 2004 or 2005. I'm willing to accept that there really isn't a lag, and that it was too tight by 2006.

The article includes the following chart, using a 1-year lag in the Fed Funds rate to support the statement that: "Other statistical indicators of housing-sector activity display strikingly strong correlations with the federal funds rate.  The first figure below shows that rapid growth in residential investment over the period from 2003 through 2005 was preceded by very low settings for the federal funds rate."

Their chart only goes back to 2000.  I have added a Fred chart of annual growth in real residential investment, back to 1967.

The idea that loose monetary policy created a housing bubble is entirely dependent on high prices.  And high prices were entirely dependent on the lack of real residential investment in specific localities.

So, the irony is that there is a dual claim here, involving public policy errors.

Add caption

1) The Fed erred by being too loose in 2003-2004.

and

2) The Fed erred by being too tight after the housing market collapsed.

The irony is that the second claim is absolutely correct, and that the reason the second claim came to be true is because so many people falsely believed claim number 1.

And, the problem is that it is claim number 1 that seems to motivate so much of the policy debate.  Claim number 1 is certainly the primary influence on public policy for the past decade.

It would be really nice if economists in general found something more useful to worry about than having too much real investment.

Upside Down CAPM, Part 4: National Debt

The basic premise of the Upside Down CAPM (comment if you have a better name for the concept) is that there is a pretty stable expected real rate of return on at-risk assets.  This is about 7%-8%.  The problem with at-risk investments isn't that the expected rate of return changes much over time.  It's that realized returns over short time frames are highly volatile.  (This is why NGDP level targeting would be so beneficial.  Those short term fluctuations are waste.)

My hypothesis is that the waste isn't expressed much in the rate of return on at-risk assets.  Held over long periods of time, real returns are somewhat stable.  There are some persistent real shocks that change long term returns, so long term returns aren't completely stable, but variance on total returns to equities starts high and then declines regularly as the holding period increases.

Any asset manager knows this, and so savers with longer holding periods are more likely to hold equity positions.

In the context of the Upside Down CAPM, my point is simply that the basket of total assets, accounting for some maintenance reinvestment, is basically a perpetuity.  Diversified equities, the proxy for that basket of assets, are a perpetuity.  This long-term stability and mean reversion means that expected returns of equities tends to remain around 7%-8%, and long-term investments reflect this long-term stability.  The sharp changes in valuation are mostly due to short term shocks, real and nominal, and the fickle nature of the valuation of a perpetuity with minor shifts in cash flow and long term growth expectations.  The portion of ownership we call debt is simply a subset of this basket where some capital, seeking shorter durations and more cash flow certainty, pays a fee for that certainty.

So, right now, highly rated corporate bonds pay a little less than 4%, or about 2% in real terms.  The Upside Down CAPM approach says the proper way to think about this is that some subset of the capital base is paying a 5% annual fee in order to receive 2% annually rather than receiving 7% annually with short term fluctuations.  Debt supply is mostly a transaction where savers are paying a convenience fee for keeping their capital safe for future consumption.  It just happens that in developed economies, the base return on capital - 7%-8% real - is high enough that the fee paid for certainty still leaves a residual return that is greater than zero....most of the time.  As we have seen recently, this doesn't have to be true.  Zero is not particularly important, especially in real terms.

Equity holders currently expect about 9% returns (roughly 2% inflationary capital gains + 2% dividends + 3% buybacks + 2% real growth).  The 7% + inflation figure is pretty stable.  There are some small shifts between growth expectations and capital payouts over time.  So, for instance, in the late 1990s, growth expectations were high.  Since the real return of 7-8% doesn't change much, that mostly meant that dividends and buybacks were lower, and PE ratios were higher.  Since those growth expectations are negatively correlated with risk aversion, the fee lenders required for capital protection at the time was very low - maybe 2%, so that bonds paid close to 5% real returns after the discount.

If we think of national public debt through this framework, I think this argues for (1) less concern about the level of debt outstanding and (2) a higher standard of returns on public investments.  As a first conceptual step, I don't think there is much difference between funding public spending with taxation or borrowing.  Either way, $x in capital is removed from the private stock of capital.  If spending is funded with borrowing, that is just a separate transaction where the government is providing the service of capital protection.  So, deficit spending is really a combination of two transactions.  First, taxation and spending.  Then, a transaction where the government accepts cash and promises to protect it, with some interest, and pay it back in the future.

Thinking of public debt in this way, I think the typical understanding of deficit financed spending being stimulative is overstated.  The spending part of the transaction is the same either way.  If there is anything stimulative about the deficit financing, it is just that the government has a competitive advantage in providing capital protection services.  Comparing treasury yields to investment grade corporate bonds, this amounts to a little more than 0.5% on average.  The reason deficit spending is useful in a contraction is if that spread rises, then that is an indication that the public service of providing capital protection is especially valuable.

So, it is stimulative.  But, only to the extent that it provides this service.  It is better to think of this stimulus in terms of the spread between AAA-rated private securities and treasuries than to think of it in terms of the government borrowing cheaply to inject spending into the economy.  There is no injection of capital here.  It is just a transfer between a saver and a lender.  And, if spreads are relatively low, then it is a service that can nearly as easily be provided in the private sector.  For a few months in late 2008 and early 2009, that spread was more than 3%.  The spread could have been brought down by more accommodative monetary policy that would stabilize nominal activity.  Eventually it did.  But, lacking that, massive public debt expansion was valuable then, including actions like guaranteeing GSE MBSs to reduce spreads.

As long as public debt levels are low enough that they don't induce a credit spread, then the public benefits from having the government provide this service.  Debt outstanding is just a measure of the extent to which there is demand for that service and the government is meeting it with a supply of capital protection.

But, this argues for a high required return for public investments.  In private markets, at-risk investments are expected to return 7%-8%.  The spread between private bonds and public bonds is only about 0.5%.  So, public spending has a small advantage over private spending because of the government's ability to provide this service.  But, in order for public spending to be more valuable than private spending, it still needs to return something like 6.5%-7.5% or more to justify taking that capital out of private markets, even with the public advantage in providing capital preservation services.

This also means that high real interest rates are probably not something that we need to fear in the context of the national budget.  High real long term interest rates will only happen if risk appetites and growth expectations rise.  As in the late 1990s, this would be associated with rising growth, innovative investments, and rising federal revenues.  In the late 1990s, the relative weights of these factors was so favorable, that federal officials feared a shortage of treasury securities might develop among institutions that utilize them.

Wage pressure is not inflationary.

The employment cost index for the first quarter continues to show some moderate strength.  This has led to new discussion about inflation, etc.

I have written a few posts about the Phillips Curve - the idea that wage growth and inflation are related, or that rising wages lead to rising inflation.  I don't think this relationship works the way it is generally described.  Monetary inflation should certainly cause wages to rise just as it should cause all price levels to rise.  Clearly there is causation going in that direction.  I think the apparent causation going in the other direction is misleading.  It is a matter of only feeling parts of the elephant.

One main piece of evidence that makes it look like rising wages lead to inflation is that firms report tight profit margins that are being squeezed by rising wages.  They either have to raise prices or reduce profits.  It seems likely that this would produce price pressure.  The idea of cost-push inflation is alluring, but not useful.

First, there are two potential sources of wage pressure.

1) Rising capacity utilization.

2) Fundamental productivity growth.

On point 1, as unemployed workers return to the labor force and the pool of potential workers declines, there are pressures on wages.  But, an economy running below capacity is not a productive economy.  In this context, both wages and profits should rise, but this should be more than compensated for by the boost in productivity caused by utilizing productive capacity.  Wage and profit growth should be real, in this context.  If anything, this sort of growth should be disinflationary as real growth would be strong.

On point 2, it is difficult to grasp in real time the full complement of mechanisms that are in play.  And, we will be more likely to see ailing, dying industries that we are familiar with than new, disruptive industries that are the source of new productivity.  Here, also, it will appear that rising wages are inflationary, but they are not.

Here, it might be useful to think of Amazon vs. brick and mortar book stores.  Wage growth was strong in the late 1990s, and it would have been tempting to look at rising wages at brick and mortar book stores, and to forecast inflation.  That is because those were mature businesses, so they had a very stable and understandable cost structure.  Wages were rising, and they either had to raise prices or lose profits.

But, what we were seeing there wasn't price pressure.  What we were seeing was productive transformation in an economy.  What we were seeing was the end of a business model that wasn't profitable any more.  When any business model comes to the end of its life because of new innovation and productivity, it will look like it is suffering from cost pressures.   But, to the extent that those cost pressures were acute, they simply led to the transformation to new, more productive business models.

Amazon, on the other hand, was hiring like mad.  And, nobody was looking at Amazon as a source of inflationary wages.  That's funny, really.  Because, since Amazon was young, they were not particularly profitable themselves.  But, nobody looks at a young, disruptive company and says, "Oh, labor costs are cutting into their profits, this could lead to inflation."  That's because Amazon wasn't trying to become profitable by cutting costs.  They were trying to become profitable by hiring and growing.

There was a lot of that going on in the late 1990s.  So, profits were low, wages were growing, and inflation was moderating.  And, the stock market didn't seem too put out by the whole state of affairs.

By the way, interest rates were also high at the time, but they weren't high because the Federal Reserve was trying to discipline risk-takers by sucking cash out of the economy.  They were high because investors were risk-takers, and so the safety of fixed income was not highly valued at the time.  The appetite for risk wasn't expressed through borrowing.  It was expressed through Amazon's rising stock price.  It was expressed through expanding equity, not debt.

Rising wages are a sign of progress.  They are something to be encouraged, not tempered.  When wage growth is strong, real interest rates might naturally rise, but there is no reason to try to force them to in order to stop the business cycle.