The Secret of the Weak Recovery: We Had a Fucking Housing Bubble with Nothing to Fill the Gap It Created

Monday, May 6, 2013 by Beat the Press / CEPR
by Dean Baker

The problem with economics is not that it's too complicated; the problem is that it's too damn simple. This problem is amply demonstrated by all the heroic efforts made by economists to explain the weakness of the current recovery.

We've had economists tell us that the problem is that we are now a service sector economy rather than a manufacturing economy. The story is that inventory fluctuations explain much of the cycle. Since we don't inventory services, we will have a slower bounceback in terms of production and employment. (There is a simple problem, since we don't inventory services, the downturn should also be less severe in a service dominated economy. How does this story fit with the worst downturn since the Great Depression?)

We've also been told that the problem is underwater homeowners who can't spend like the good old days because they are underwater in their mortgages. The problem with this one is that we only have around 10 million underwater homeowners, the vast majority of whom have relatively modest incomes. The emphasis is on "only" because, while 10 million is a lot of people to be underwater, it is not a lot of people to move the economy.

The median income for homeowners is $70,000. (Median is probably appropriate here rather than average, since it is unlikely that many wealthy people are underwater.) Suppose that being above water would increase consumption by each of these homeowners by $5,000 a year. This is a huge jump in consumption for people with income of $70k. (Do we think these homeowners are saving an average of $5,000 a year now?) This would lead to an increase in annual consumption of $50 billion a year or less than 0.3 percent of GDP. This would be a nice boost to output, but it would not qualitatively change the nature of the recovery.

Today we have Robert Samuelson telling us that the reason employers are not hiring is uncertainty:

"Businesses have become more risk-averse. They’re more reluctant to hire. They’ve raised standards. For many reasons, they’ve become more demanding and discriminating. These reasons could include (a) doubts about the recovery; (b) government policies raising labor costs (example: the Affordable Care Act’s insurance mandates); (c) unwillingness to pay for training; and (d) fear of squeezed profits."

Hmmm, they're worried about squeezed profits when the profit share of income is at its highest level in more than 60 years? The story of the Affordable Care Act raising costs could at best only explain the behavior of a small group of businesses (firms with close to 50 employees who do not currently provide health care insurance).

But there is a simple way to test the idea that firms would otherwise be hiring but are deterred due to uncertainty about the future: look at the length of workweeks. The logic is simple; increasing hours per worker and hiring more workers are alternative ways to meeting increased demand for labor. Adding work hours involves none of the commitments that apply to hiring addtional workers. If uncertainty, as opposed to lack of demand, is keeping businesses from hiring, then we should be seeing a big increase in the length of the average workweek.

We don't. The length of the average workweek fell by 0.2 hours to 34.4 hours in April. This compares to an average of more than 34.5 hours in the 2006 and 2007. In short there is no evidence that employers are seeing the sort of demand that would justify increasing the size of the workforce but are being kept from doing so because of the concerns raised by Samuelson.

If none of these stories, or any of the others that economists develop to stay employed, explain the length of the downturn, what does? Well, it's pretty damn simple, we had a housing bubble driving the economy before the collapse and there is nothing to fill the gap created. The bubble led residential construction to soar to more than 6.0 percent of GDP at the peak of the boom in 2005. It is now a bit over 2 percent of GDP implying a loss in annual demand of more than $600 billion. The $8 trillion in housing wealth created by the bubble led the saving rate to fall to almost zero due to the housing wealth effect (people increase annual spending by 5-7 cents for each dollar in housing wealth). With the saving rate hovering near 4 percent, we have lost close to $400 billion in annual consumption demand.

The cumulative loss of annual demand is more than $1 trillion. What did we think would replace this demand? Investment in equipment and software is actually close to its pre-recession level measured as a share of GDP. Furthermore, this component of investment has never been a much larger share of GDP, even in the Internet bubble years. Why would anyone expect it to expand rapidly at a time when many firms still have large amounts of excess capacity? (Structure investment is depressed because there was a bubble in non-residential construction as well, leading to large amounts of excess capacity in most areas of non-residential construction.)

Do we somehow think that consumers will spend at the same rate after they have lost $8 trillion in housing wealth as when they had this wealth? Why? Net exports could fill the gap, but the dollar has to fall. Net exports could fill the gap, but the dollar has to fall. (I repeated that one in case any economists are reading.) The value of the dollar is the main determinant of our trade deficit, if we want a lower deficit then we will need a sharp decline in the dollar, which has not happened.

This only leaves the government sector to fill the gap with deficits, which our Serious People types have demanded that we hold down. So, based on the good old intro econo that tens of millions have been subjected to, we know that this recovery will be slow and weak. We simply lack a component of demand to fill the gap created by the housing bubble.
If it seems absurd that economists can't see something this simple, readers should realize that this is a common problem. Just last Friday Robert Samuelson had a useful column that pointed out the huge imbalances that persist in the euro zone and pointed out that the region's crisis is far from over. While he is exactly right, the amazing part of the story is that competent economists somehow did not see these imbalances developing.

As I pointed out, several of the current crisis countries already had incredible trade deficits long before the crash as the world's leading economists were celebrating the "Great Moderation."

Current Account Balance as a Percent of GDP

Country	2003	2004	2005	2006	2007	2008
Greece	-6.533	-5.785	-7.637	-11.388	-14.609	-14.922
Portugal	-6.433	-8.327	-10.323	-10.685	-10.102	-12.638
Spain	-3.508	-5.248	-7.353	-8.961	-9.995	-9.623

                                           Source: International Monetary Fund.


How did the folks at the European Central Bank think that these deficits would fall to a sustainable level without some sort of disastrous crisis? This one should have been simple, but the world's leading economists all missed it.

I recall back in the 1990s and the last decade when both Republican and Democratic economists wanted to invest Social Security funds in the stock market. (Democrats generally wanted to invest the fund collectively rather through individual accounts.) I tried to point out that both were assuming impossible rates of return given the fact that the stock market was at price to earnings ratios that were far higher than historic averages.

When this issue was highlighted in the debate over President Bush's privatization plan (see the No Economist Left Behind test) Brad DeLong suggested that we do a paper on it for Brookings conference. I didn't think that this simple arithmetic could warrant a Brookings paper, even though the issue was hugely important. To get it in Brad (along with Paul Krugman) added a model of optimal consumption paths given a declining rate of labor force growth. While the model was fine, it had nothing to do with the basic issue that the stock market was over-valued at the time that people were thinking of investing workers' Social Security money in it. The model did add sufficient complexity so that we get the Brookings crew to take the simple argument seriously.

The same story held during the housing bubble years. I had many people ask me why I didn't publish anything in journals on the bubble in the years 2002-2007 when I was writing for CEPR's website and popular publications. The reason is that it was too simple a story for any serious journal.

The basic story was that house prices had diverged sharply from their long-term trend and there was no plausible story rooted in the fundamentals of the housing market that could explain this divergence. While this was certainly compelling in my view, the American Economic Review is not going to publish an article that shows house prices just keeping pace with inflation for 100 years and then suddenly rising by 70 percent in real terms from 1996-2006. It would be necessary to somehow make the story complicated to get economists to take it seriously.

To my view this is the fundamental problem of economics. There is a need to find ways to make economic issues complex even when they can be explained by the simple economics that we teach in econ 101. This is not a pretty picture.

Failure of the Super Committee Might Be the US's Best Hope for Economic Recovery

"Drawing blood” from the economy by cutting government expenditures at a time of high unemployment and underused resources will only ensure the patient’s death, not recovery. 

By Marshall Auerback, AlterNet
Posted on November 26, 2011

The bipartisan super committee has failed to meet the self-imposed November 23rd deadline to enact $1.2trillion of cuts over the next ten years. That failure, as Paul Krugman notes in the New York Times, is a good thing:

“Any deal reached now would almost surely end up worsening the economic slump. Slashing spending while the economy is depressed destroys jobs, and it’s probably even counterproductive in terms of deficit reduction, since it leads to lower revenue both now and in the future.”

If the super committee failed to come up with an alternative plan by Thanksgiving, and the cuts will hit defense and domestic programs equally. But those cuts won’t begin to go into effect until January 2013, two months after next fall’s election, which also means that the programmed fiscal restriction planned for next year won't come into effect. The likelihood of failure is provoking a negative reaction in both the markets and the mainstream press. But in spite of that, failure might be the difference between sluggish, moderate growth in the U.S. and double dip recession.

The travails of the euro zone are perpetual front page news right now, but let's try to put them aside for a moment and focus solely on the U.S. The latest U.S. economic data suggests that the economy has continued to muddle along at a positive rate of growth somewhat below its trend rate of growth. This has happened even though an unwind of the 2009 $860 billion stimulus package is now leading to moderate reductions in government spending.

October core retail sales were up +0.6%. The three-month annualized change now stands at +6.6%. This is consistent with personal consumption expenditure growth of perhaps +3.0%. The increase is consistent with the above trend U.S. economic growth.

Dallas Fed President Richard Fisher thinks such growth is sustainable. He expects U.S. economic output to grow +2.5% to +3.0% in this quarter and expects it to improve next year.

But not if the super committee goes big and enacts huge budget cuts. In that kind of scenario, economic growth in the U.S. next year will be held back (or worse) by programmed fiscal restriction as even greater amounts of income are withdrawn from the economy, especially if cuts are implemented in programs such as Social Security. Lower incomes means lower sales, and sales are what ultimately drive economic activity. 

Remember: businesses lay people off when their customers stop buying, for any reason. So the reason we lost 8 million jobs almost all at once back in 2008 wasn't because all of a sudden all those people decided they'd rather collect unemployment than work. The reason all those jobs were lost was because sales collapsed.

I am also skeptical of the validity of the recent strong trend in consumer spending because it appears to be a product of consumers drawing down on savings, which began to be rebuilt in the aftermath of the 2008 crash. Unfortunately, consumers no longer have the credit availability to do that. Nor do they have the incomes to sustain taking on ever increasing burdens of private debt, as was the case in the 1990s.

And let’s be clear: Despite the distortions floated by many politicians and pundits in the mainstream press, most of the growth of the government’s deficit can be attributed to the rotten economy–which destroyed jobs and thus tax revenue. As the U.S. private sector retrenched to rebuild its balance sheet, the government’s balance moved toward deficit. This had very little to do with “excessive” and “unsustainable” entitlement programs. The positive contribution of the U.S. fiscal stimulus (with supporting monetary policy) cannot be overstated, even though many notable mainstream economists (such as Robert Barro, or Greg Mankiw) claim it made the recession worse. Without the two-pronged attack – first of shoring up the financial system to ensure the banks could lend and second, the substantial increase in government net spending (which was both the product of discretionary fiscal decisions and what economists call "automatic stabilizers" like unemployment benefits) – the world economy would have collapsed into Depression. That is not to say that the fiscal interventions were sound and well designed. I generally think they were unsound in the sense that they did not support job creation as much as they should have. But that is a separate issue.

The outlook for 2012 then depends very much on fiscal policy. Right now according to the Congressional Budge Office (CBO), we are programmed for fiscal restriction of perhaps 2.5% of GDP or more in 2012. That could overcome the natural tendency of economies to grow, especially with real interest rates at negative levels. The question then arises, will we really go through an election year with so much fiscal restriction? The answer, of course, is in the hands of the politicians. As it now stands, the President wants a $447 billion dollar jobs plan. That is equal to almost 3% of GDP. He wants most of it to be financed with borrowings in 2012, with offsetting tax increases in future years. Passage of all of this jobs plan would turn programmed fiscal restriction into marginal fiscal stimulus.

The Republican position has been that, even if they go along with parts of this job stimulus plan like an extension of the payroll tax cut, they demand offsetting greater expenditure cuts.

In other words, even if they concede to some of Obama’s demands, they insist on maintaining the overall fiscal restriction that is now programmed because they say that demonstrating a commitment to “budget discipline” will enhance business confidence and allow the private sector to create more jobs.

So let’s assume that the GOP is right: imagine a new government being elected on the promise of cutting national debt and in its first budget outlines a very clear plan to seriously cut the national budget deficit, reduce taxes (but definitely not put them up), cut public employment and free up the regulative environment. And let's say that such a government also pronounced its “pro-business” credentials (self-styled).

In that situation, if the Republican view was correct, we would expect to observe within a few months (certainly within a year) of the new government a reduction in private uncertainty, which, if the concept has any operational application, should influence discretionary behavior such as spending and employment.

It would be reasonable to expect business confidence to rise, which should mean that private investment would accelerate as business owners anticipate a consumer revival. It would be reasonable to expect firms to be keen to get staff in place to meet the renewed expectations of increased orders. It would be reasonable to expect consumers to become more confident and this confidence to translate into their consumption expenditure.

So... how does one explain the UK, which continues to deteriorate in spite of making very clear its plans and implementation for budget cutting? And how does one explain Australia, which has also been working toward reducing government spending, even as its unemployment rate has begun to tip up again?

The economics of the super committee, indeed that of virtually all of the mainstream Washington policy establishment, is still predicated on the economic equivalent of Medieval blood-letting. Continuing to “draw blood” from the US economy via ongoing cuts in government expenditure at a time of high unemployment and underused resources will ensure the patient’s death, not recovery.

Bank Profits Depend on Debt-Writedown `Abomination'

By Bradley Keoun and David Henry - Jul 11, 2010

Bank of America Corp. and Wall Street firms that notched perfect trading records in the first quarter are now depending on an accounting benefit last used in the depths of the credit crisis to prop up their results.

Bank of America, the biggest U.S. bank by assets, may record a $1 billion second-quarter gain from writing down its debts to their market value, Citigroup Inc. analyst Keith Horowitz estimated in a June 23 report. The boost to earnings, stemming from an accounting rule that allows banks to book profits when the value of their own bonds falls, probably represented a fifth of pretax income, Horowitz wrote.

Investor fears of a Greek default, stalled U.S. economic recovery and tougher industry regulations have rattled markets, snapping banks’ trading streaks and rekindling doubts about their creditworthiness. Prices for Bank of America’s credit derivatives -- used by traders to bet on the likelihood of the firm’s default -- rose by 34 percent during the second quarter, while Morgan Stanley’s doubled and Goldman Sachs Group Inc.’s surged 86 percent.

“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”

Statement 159

In the first quarter, the four biggest U.S. lenders -- Bank of America, JPMorgan Chase & Co., Citigroup and Wells Fargo & Co. -- produced combined profit of $13.5 billion, the most since the second quarter of 2007. That figure probably fell by 28 percent in the second quarter, based on a Bloomberg survey of analysts’ estimates. The banks are scheduled to announce results over the next two weeks, led by JPMorgan on July 15.

The second-quarter results may include gains taken under a U.S. accounting rule known as Statement 159, adopted by the Financial Accounting Standards Board in 2007, which allows banks to book profits when the value of their bonds falls from par. The rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount.

Accounting ‘Abomination’

In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York.

“Just because Morgan’s credit spreads widened out this quarter doesn’t mean that their ultimate interest and principal payments changed one iota,” Kotowski said. “The market will back it out, both on the upside and the downside.”

Kotowski has been covering the banking industry since 1987 and returns on his stock recommendations over the past year have outperformed the average of peer analysts, according to data compiled by Bloomberg. He has been discounting the valuation gains from his analysis since at least the third quarter of last year, and wrote in an October 2009 report that the “after- effects of a hundred-year storm are not shaken off in a couple quarters.”

Morgan Stanley probably recorded $1 billion in such debt- valuation adjustments in the second quarter, Citigroup’s Horowitz wrote. That represents 60 percent of the analyst’s forecast for the firm’s pretax income. Morgan Stanley booked $5.1 billion of gains in fiscal 2008 as its bond spreads widened, then reversed them in 2009 as markets improved and spreads tightened.

Goldman Sachs may have had $375 million of gains in the second quarter, while JPMorgan had $300 million, Horowitz wrote.

DVA Gains

Including Bank of America, the four banks probably had debt-valuation adjustments, or DVAs, amounting to an average of 18 percent of pretax income, based on Horowitz’s estimates.

Citigroup may have booked $400 million under the accounting rule, estimated Bank of America analyst Guy Moszkowski.

“It’s deja vu to 2008,” said Credit Agricole’s Mayo. “DVA gains are back.”

In the first quarter, an unbroken string of profitable trading days helped Charlotte, North Carolina-based Bank of America post higher profit than analysts estimated, even as unemployment stayed close to a 27-year high. Goldman Sachs, JPMorgan and Citigroup also reported perfect trading quarters, while Morgan Stanley was profitable on 57 of 61 trading days. All four firms are based in New York.

“The credit cycle is clearly behind us,” Bank of America Chief Executive Officer Brian Moynihan told investors in April following the bank’s first-quarter earnings report.

‘Prevailing Winds’

In the ensuing months, corporate-bond yields widened, leading to a “pullback in client participation” and lower fixed-income trading results, Steve Stelmach, an Arlington, Virginia-based analyst at FBR Capital Markets, wrote in a June 30 report. Non-investment-grade bonds lost 0.7 percent last quarter, compared with a total return of 4.82 percent in the first, based on the Bank of America Merrill Lynch U.S. High Yield Master II Index.

“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much,” said David Hendler, a senior analyst at New York-based research firm CreditSights Inc.

The Standard & Poor’s 500 Index fell by 15 percent from a 19-month high in April, curbing stock-trading revenue and prompting companies to cancel or postpone new share offerings and hold off on mergers and acquisitions that Wall Street bankers advise on to generate fees. U.S. bond sales fell to $335.8 billion in the second quarter, down 37 percent from both the first quarter and the second quarter of 2009, according to Bloomberg data. It was the lowest amount since the fourth quarter of 2008.

Lackluster Demand

The weaker trading environment highlights how banks are suffering from lackluster demand for their basic products: loans to companies and consumers. Loans and leases held by U.S. banks shrank for the sixth consecutive quarter to $6.88 trillion as of June 30, according to Federal Reserve data, which include an accounting change. Delinquencies on commercial real estate loans rose to 7.5 percent in May from 6.42 percent in March, according to Moody’s Investors Service.

Citigroup, which is 18 percent owned by the U.S. Treasury Department, probably had net income of $1.54 billion in the second quarter, the average of eight analysts’ estimates in a Bloomberg survey, down 65 percent from the prior quarter and 64 percent from a year earlier.

“Our near-term performance will continue to reflect the pace of economic recovery and the level of activity in capital markets,” Citigroup CEO Vikram Pandit, 53, said in April after the bank’s first-quarter profit almost tripled from a year earlier.

Goldman, Morgan Stanley

Profit probably fell 25 percent at Bank of America from the second quarter of the previous year, 18 percent at San Francisco-based Wells Fargo and 47 percent at Goldman Sachs, the Bloomberg survey shows. JPMorgan’s profit, which probably rose 17 percent from a year earlier, may be 4.5 percent lower than it was in the first quarter. Morgan Stanley’s second-quarter profit, depressed a year ago by a $2.3 billion debt-valuation charge when its CDS spreads were tightening, probably rose sevenfold, according to the survey. Compared with the first quarter, Morgan Stanley’s profit probably fell by 35 percent.

At the same time, banks are adding jobs for the first time in two years in a bet that recent market turmoil will prove temporary and fewer U.S. consumers may fall behind on loan payments. In New York, 6,800 financial-industry positions were added from the end of February through May, the largest three- month increase since 2008, according to the New York State Department of Labor.

‘Unusually Weak’

JPMorgan last month reported that credit-card loans more than 30 days late fell to 4.22 percent from 4.4 percent the previous month. That was the lowest since July 2009.

None of the six largest banks is forecast to report a loss for the second quarter, a contrast with the fourth quarter of 2008 when they had combined net losses of $25.3 billion.

Any optimism was lost on the market for bank stocks. The KBW Bank Index, which tracks the 24 biggest U.S. banks, fell 11 percent in the second quarter after climbing 22 percent in the first three months of the year.

“The first quarter was unusually strong, and the second quarter feels like it is going to be unusually weak,” Moshe Orenbuch, an analyst at Credit Suisse Group AG in New York, said in an interview.