Prognostications On The Economy (update 6-26)

Most people reading this blog will have read some prognostications on the economic future of the next 1-2 years, talking of what will happen in 2010.

These longer-term forecasts are fantasies.

While the mainstream prediction of some economic stabilization this year followed by modest GDP growth and continuing job losses makes sense, even this middle-of-the-road 6-month forecast is similar in reliability to a 2-week weather forecast during the spring or fall.

It might happen that way.

Exactly like a weather forecast, and for precisely the same scientific reasons, economic forecasts are relatively useful for a short-term outlook, and less and less meaningful for a longer term outlook.

I'm quite deliberate in this choice of language. Just as randomness changes the weather progressively more over time versus any specific scenario, the same effect applies to large economies. But while long-term weather usually follows seasonal averages with moderate deviation in most years, the long-term economy has more randomness and higher deviations.

Right now the biggest unknown is future evolution of expectations and the consequent choices individuals will make in response.

This is not at all predictable.

We can predict some aspects of the economy, such as national housing price changes, due to the highly consistent effects of supply versus demand -- when the supply of homes for sale is significantly more than 6-7 months worth, prices fall. The effect of significant supply along with significant expected shadow inventory (those with houses not currently on the market who would like to sell, and are waiting for the recession to ease) practically guarantee further price falls in many areas, and on national averages.

But some critical economic factors in the broad economy are fully unpredictable. That is, the degree of unforeseeable change is very high.

The economy is, after all, the joint decision of all of us together.

We can en masse pull back on our spending out of fear of job losses, creating a self-fulfilling outcome of continuing high job losses.

Or we can en masse gain confidence in the economy, and thus feel more secure in our jobs, and spend a little more, creating a self-fulfilling outcome of reduced job losses, and even an improving economy.

The most crucial part of the stimulus program -- the American Recovery and Reinvestment Act of 2009 -- is how it affects general confidence in the economy.

This is because general confidence will determine changes in consumer spending of greater scope than the amount of actual stimulus spending.

A popular forecast like "weak growth of 0.5% in the 2nd half of the year" is only a guess.

Fortunately, one of the greater forces in the economy has changed direction.

We can all breathe a little easier to see this news today:

Consumer confidence extended its rebound in May, soaring to the highest level since last September as more shoppers are feeling the worst of the recession is behind them....

This is no small thing.

Sufficient confidence could give the actual stimulus dollars much more traction, leading to a very different economic outcome over time. How different? Well, long-term interest rates for instance depend on investor confidence in America, which in turn depends on the American economy, which itself depends on small changes adding up over time...

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Update 6-26

(Reuters) - U.S. consumer confidence rose in June to the highest since
February 2008, as expectations grew that the worst economic recession since the
Great Depression may be ending, a survey showed on Friday.

Today we also learned the savings rate has shot up to 6.9% for May from 5.6% in April. New unemployment claims are still very high, ticking back up a bit.

But of all the indicators, most key are confidence and actual consumer spending (up 0.3% month over month).

These two suggest some possibility of real stabilization, instead of a downward spiral. What's unknown is how many layoffs have been delayed on hope of a bigger rebound in spending. The next 2 months will decide if this stabilization is firm, or only a pause. But I'm cautiously hopeful that this stabilization can hold, so that the economy may be at the bottom here, instead of a worse scenario. It's not certain, but it's a good sign.

Elizabeth Warren on Charlie Rose

Elizabeth Warren appeared on Charlie Rose last night.



Warren has lately appeared in many places (here's a new link to an unedited Planet Money full interview, and even "Tech Ticker"), which is encouraging, as she is talking of the most important situation/issue facing the country: the increasingly impossible situation of the middle-class squeeze. Unlike many prominent commentators though, Warren has real insight into some of the causes (another couple of fundamental causes and also solutions are a significant part of the book I've been writing). Instead of only being a raised voice or trying to present an economic ideology though, Warren gives non-ideological insight, and actually pinpoints some of the real causes.

So what happens when a clear, non-ideological mind like hers faces the labyrinth of money and influence and interests that is the TARP and the current situation? It's a fascinating moment in American history.

She cut through the fog to say the heart of the problem is indeed what's happening in the American family. This is true in that there were forces that pushed families into the choices they made, which in combination with choices banks and nations made (for instance the Chinese monetary policy of holding down their currency value) helped create this situation and outcome which is now threatening a world-wide depression.

I think she's right we have to address the problems faced by American families (specifically the problems of families with kids), of which there are several pieces, in order to be able to solve the big economic problems. For instance, banks' continuing troubles flow from continuing loan defaults (on mortgages and credit cards and auto loans, etc.) But the start and base source of loan defaults is from the middle class squeeze, which preceded the recession, and even if the recession eases will still keep banks in trouble and at risk, crimping normal lending.

Warren has superior insights versus many popular opinions. For instance, contrary to the popular perception of families buying fancy houses they could not afford is the bigger, far more widespread reality of a larger number of families that brought very average houses which were expensive and which they could not afford because they were competitively bidding up house prices in locations with good schools, which appear key to a successful life for their kids. Instead of getting sidetracked by the appearance that many "average" houses in newer areas are bigger than houses used to be, Warren cuts through the fog and pinpoints what's really happening: competitive bidding to be inside good school districts, whether in newer neighborhoods, or old. Small, 1950s era houses in the East have been bid up right along with the newer houses in the South.

That's an insight. Warren's insight.

That's a clear pinpointing of the real situation.

Fixing the big economic situation finally comes down to several specific problems, some complex, some quite simple. The insight is to be able to figure what really matters and what is more a side issue. There are even some simple problems that really matter, in addition to some complex problems (complex for instance are such as fixing banks or the situation of education and competition for schools). So in addition to talking about complex problems, Warren also talks sometime of simple problems. Credit card deregulation in the 70s and 80s for instance leading to the current unsustainable, theft-like practices. Sometimes to fix an engine you need to fix several things, and you have to fix them individually, even the smaller issues. So even with a major fix like a timing belt, you might still have to fix a relatively simple problem like a bad spark plug wire.

Warren has found some of the trouble other mechanics did not, and that makes repairs easier.

The Best of the Week

As a regular feature I'll be posting on the weekend a Best of the Week, which will occasionally be updated on Sundays also (if not posted on Sunday to begin with). Work is proceeding on the final draft of the book I've been working on (see my profile).

This week a couple of pieces stood out for drama:

Charlie Rose had an interview with Neel Kashkari (notes below):



some interesting moments (times):

9-11 minutes: house prices, loan modifications, what will end the "housing crisis"
17-23 minutes: the $700 billion, the crisis, the changes, the reasoning
24: "Nationalize (sic) the banks" vs. reality

...

And not to be over-shadowed, Adam Davidson, whom is usually fun to listen to, ended up going overboard on Elizabeth Warren, finally resorting to labels and pigeonholes. Of course, such don't fit so well. If Elizabeth Warren is "left", then the left is smaller than I thought, and we'll be needing a new label (or not) for what used to be "left". If you listen, here are a few economists Adam forgot when he said no economists agree that the problem of household debt is a central, primary problem on par with fixing banks (and I'm including any public/blog/interview statement to the effect that consumer/household debt is central and a main source of the problems banks face):

Ken Rogoff
Timothy Geithner
Nouriel Roubini

There are more (for instance Krugman has suggested this a few times lately), but these three could suffice. (Still if readers want to suggest more or offer links, I'll include them).

Notice these three don't fit in a common pigeonhole, unless it's "realist".

Ok, here's the link for that interview.

We hope Adam will re-balance. Sometimes a person has to make a mistake in order to find their own next step.

Update: After Adam's apology Monday, Planet Money posted the full unedited interview on Tuesday, which really is a lot more interesting.

...

One broad point I'd like to make: No one really knows the economic future. We have profound insights such as from Irving Fisher, but even standing on the high platforms of insights such as these don't afford a clear view through the fog of all the ever-changing decisions and efforts that together will sum and multiply and modify each other into true complexity.

One insight I can offer: ultimately our economy is a joint decision of all of us. We can indeed decide to move up, down, or in a new direction, and the mass decision of tens of millions moving together in response to the bully pulpit is no small matter. It could be decisive.

Poll: 70% Have Cut Back on "Luxuries", 40% on Necessities

Forty percent said they had cut spending on luxuries, and 10 percent said they had cut back on necessities; 31 percent said they had cut both. -- New York Times/CBS Poll

Of course, if 40% have cut back on luxuries, and another 31% on both luxuries and necessities, then 71% have cut back on luxuries.

But the stark number is the total of about 40% that have cut back on necessities.

This leaves open the question of whether eating out is considered a luxury or a necessity by respondents. But if eating out is a luxury for many now, then what necessities might be cut by as many as 40% of Americans? Variety of food eaten at home might be one necessity that could be cut back on. Auto maintenance might be another. Health care is certainly being cut back on by many.

We can only hope that the necessity of good nutrition is not being cut back too much by too many.

Americans took on an additional $5 trillion in mortgage debt from 2001 to 2007. Since roughly 51 million homes had mortgages at the end of 2008, this amounts to roughly $100,000 more mortgage debt owed on the average home than in 2001. Even at a favorable mortgage rate of 5.25% for instance, that $100,000 costs about $550/month in extra mortgage payments vs. payments levels of 2001, for an average home. Of course, some owe the same payment as in 2001 (not having moved or refinanced or taken money out), but many owe an extra amount considerably more than this average.

The interest cost of $5 trillion at 5.25% is some $260 billion per year.

That $260 billion per year (eased down a small bit with every foreclosure) is money that could have been spent in the economy on other goods and services, resulting in diverse and lasting employment for many millions of Americans.

This extra mortgage interest over just 3 years is about as large as the stimulus package.

This is what we are up against.

But there is one form of great relief and source of new strength for the U.S. economy in this dark reality.

With as many as 8 million foreclosures by 2012 (one estimate), possibly as much as $2 trillion of this debt burden could be removed from households (who become renters at typically much lower monthly costs).

Such a large amount of debt-relief (monthly living cost relief) would help the economy immensely.

We have a ways to go yet, as only 1.4 million foreclosures have accumulated since July 2007.

But Congress, which appears at times in thrall to vested interests or under the spell of clever lobbyists, does not appreciate the crucial economic stimulus foreclosure debt-relief brings to the U.S. economy. House prices return back to normal levels sooner due to foreclosures, allowing a recovery in buying (and eventually building) sooner.

We need a clearing, a chance for people to get out of homes far too expensive for them. We need these Americans back -- back in the economy -- able to live in a more economically participating way: with money to spend on more than only a gigantic mortgage payment (any payment more than around 1/3 of income). We have yet to see whether large numbers will benefit from Obama's foreclosure prevention plan to ease payments down to 31% of income. But many underwater home owners would often be better off, and the economy in turn, to let go of a home that is too expensive, lowering their monthly shelter costs even further, and have more money to spend on the other parts of life.

Such as the necessities.

There Were Signs of Distress

There were signs of distress about the economy: 60 [Sixty!] percent of respondents said that they were very or somewhat concerned about being able to pay their home costs, and 39 percent said that the decline in home prices had affected them personally.

Slightly over half said that their household income provided them with just enough money to pay their bills.

-- NYTimes

These numbers are surprisingly high -- even though we knew many American families were under an economic squeeze. Would you have thought that 60% were concerned about being able to continue paying all the costs of their home? This alarming number makes sense though if you consider that about 1/2 of American households have "just enough money to pay their bills" as the poll reveals.

This is a dramatic confirmation of the one key fact that underlies our economic woes.

Every time a nation has a housing price bubble -- when house prices rise well over the limit of about three times annual household income (of the household when purchasing the home), then the crushing burden of making this proportionally high mortgage payment *every month*, over time, gradually destroys so many household budgets that a large portion of the population progresses deeply into debt....

Deeper and deeper into debt, until....

Until the easy credit ends when the house prices finally stop shooting upward.

Then, as households are forced to pull back on their credit-fueled spending, it becomes clear that the level of economic interaction (making and purchasing) throughout the whole economy cannot be maintained.

And then, like a flexible latticework bridge with more and more pieces being pulled out of the structure, the economy begins to creak and sag. The sagging can threaten to become a major slump downward.

Outright depression is only held off by the efforts of governments.

This is how a house price bubble is one of the most destructive things that can happen to a nation. It gradually removes more and more actual (non-credit) discretionary spending power from the economy as housing costs escalate and eat more and more of available income (as gradually more people begin paying larger mortgage payments). Then, finally, as the bubble stops expanding and easy credit ends, there is a sudden drop in credit-fueled discretionary spending. So the demand for goods and services suddenly drops off to a lower level. It's like the bubble forces a hard fall.

It happened to Japan.

And now it has happened to many nations at once: the US, Ireland, Spain, the UK, Sweden, Australia, and those are not all. The fallout is not going to be easy to work past.

It would be reasonable to expect the economic difficulties of the world to last for a long while, in part because the adjustment itself -- production and wages being adjusted downward to a significantly lower level of demand (less purchases of goods and services by consumers) -- is a circular process, and even the aid of government for lending and credit makes the adjustment slow.

A slow adjustment implies a long time of economic weakness and uncertainty.

As I see it, the only thing that can speed a real recovery (instead of a painful stagnation) from a house-price bubble is exactly to achieve house prices falling all the way back down to their normal long term average levels in ratio to household incomes, and to have households that can't really easily afford their mortgage payments get out of them.

When homes are generally affordable in most places again, then the nation can recover.

It is exactly house prices falling back to where they have to be in terms of incomes that allows house prices to finally stabilize, and confidence to return.

Ironically, foreclosures, so often spoken against by our politicians, can aid many families in two important ways.

First, foreclosures help to push house prices down more quickly, so that the inevitable and necessary fall in prices ends sooner. After prices are low enough and buyers increase, confidence spreads and people feel their wealth will increase instead of falling. As an added benefit, the lower prices allow young families to afford their first home.

The subsequent turnaround from this lower house price point allows a general recovery.

Second, for many or most families that "lose" a house in foreclosure, the family budget becomes much easier when freed from especially large housing costs. They have room to breathe.

They have escaped the crushing monthly payment that not only stressed their finances and sometimes their relationships and even their health --they have also escaped the monthly burden that robbed them of a chance to save money for the future.

For many families, a foreclosure is a reprieve, and a chance to move towards a healthy monthly budget, with some savings for the future.

A family that has a mortgage modified so that instead of a crushing 40-50% of their income going to mortgage payments they are set to pay only 38%, for instance (one program under Bush), is *not* so lucky a family as we might think at first.

38% of the monthly income paid on the housing payment is still a crushing burden, even if the crushing squeeze it creates over time is slower. Slowly being crushed is not better than rapidly being crushed. In fact it is worse. Seemingly 38% can be just afforded, until....until the car needs one too many repairs or the medical co-payments add up a little too much....

A lucky family is one that escapes from any crushing 35% or 40% or 45% of income going to their housing payment and moves into a cheaper place with a payment of 28% or less of their monthly income.

But it is not widely understood by many people or many in Congress that paying over 30% of your monthly income for your housing payment leads to financial stress and even harms the general economy.

We have a ways to go yet, as few in Congress seem to understand that high house prices damage our economy.

High house prices damage America, Congressmen and Congresswomen, Senators.

They prevent us from having much of an economy, once the bubble illusion of wealth -- which is actually based on ever-higher mortgage debt -- comes to an end.

When we spend almost all our money just paying for the house, the insurance, the car and the health care, how can we afford to go out to eat or pay someone to mow the lawn or buy more gifts or the other myriads things that are the output of...

...the output of our jobs?