The MEW window?

A common discussion among economists is what the recovery will look like?  V-shaped, U-Shaped, L-Shaped or something else.  I’m inclined to think it looks like an L-ish meaning we’ll snap back some of the collapse in GDP but then settle into low level of growth.  It is hard to know what this will look like but I stumbled over something that made me wonder if we don’t have a picture of recent history that may give us an idea.  If look at the 01 recession and then take out the growth that came from MEW (mortgage equity withdraw …commonly refered to as using one’s home as an ATM) and say that this is what growth would have been with out a major source of finance you get a L-ish picture (the lower red bars).  Now taking out MEW contribution to GDP doesn’t get at all the knocking on effect of a sudden stop in the credit channel but I thought the picture was worth sharing.

Great Depression Redux?

Take a look at the new cycle chart set with an appendix comparing pre-war and post-war recession with today’s down turn and the Great Depression.

Agencies to Begin Forward-Looking Assessments (sort of)

The Federal Reserves friendly email push system sent me the following press release. Quick story line is that the regulators are going to stress test the banks to make sure they have the capital they should (weren’t they doing this all along?). Well if you open up the attachment you see the simple economic baseline that they are using.

First GDP growth: The adverse case doesn’t strike me as very adverse but it also doesn’t explain if adverse is a 1 in 3 or a 1 in 10. Likely a 1SD base on previous forecast error (not a smart way to do this). Today’s unseens forecast error is likely to be larger than normal. The adverse case should be based on modeling about the distribution of the baseline not based on forecast error over various cycles.

Second path of unemployment: This seems some what plausible to me.

Lastly home prices: Ugly; but wait where does this come from? It appears to come from the Case-Shiller Futures and a special survey.

Special survey means nearly random guess (think about how you answer special survey questions) and second and more importantly the housing futures market doesn’t trade (Open interest in 2010 for the index was 2 contracts). So in short read the above graph as random baseline..so we can pretend that we have an idea about what is going on. It would be so much smarter to admit we don’t have a good grasp of how it will play out (Or get a grasp by creating a baseline based on understanding of economic dynamics) and then test the banks on a wide range of scenarios including cases that have never happened. This path would make more sense than pretending to know based on a fake baseline.

American Recovery and Reinvestment Act of 2009

I know I’m repeating myself (a lot here) but I think this is a better quick presentation of the numbers (and when we are spending 800 billion dollar I feel like I can abuse the topic twice).

A good source of information for government fiscal information is the CBO (Congressional Budget Office). They provide analysis on of the impact of bills from congress. They are designed to be non partisan and don’t offer proscriptions but rather just the facts. (admittedly the fact in a slightly odd way because they will show what is in the law rather than what is expect (eg. they assume continued AMT, even though it is regularly adjusted, but only for one year at a time). That being said they have put out on the table a report on the fresh off the presses stimulus package. Lets skip over the ugly details that hundreds of billions are essentially non stimulative programs (not temporarily, timely or targeted) but opportunistic spending that has piggy packed on a recovery bill and focus on the headline numbers. We see a few striking things: (1) It is big, 5% of GDP over 3 years, (2) its lasts for a while, having a non trivial impact into 2011, and (3) its peak isn’t until 2010.

	2009	2010	2011	2012	2013	2014	2015
Nominal GDP	14,138	14,421	14,709	15,445	16,217	17,028	17,879
Net Impact on the Deficit	184	399.4	134.4	36.1	27.6	22.4	4.7
% of GDP	1.30%	2.77%	0.91%	0.23%	0.17%	0.16%	0.03%
% of Stimulus Spent in Year	23%	49%	17%	4%	3%	3%	1%
Impact on GDP, assuming a 1.15 multiplier	1.50%	3.19%	1.05%	0.27%	0.20%	0.18%	0.04%

The package is far from good; but it better then nothing. The spending form is the most suspect while the size is likely the closest part of the package to being right. If we are experiencing, as I believe we are, the paradox of thrift – where everyone is trying to save more but in aggregate we save less because income fall – and the classical economic concepts of prices falling stimulates quantity demand is broken because of a shock that shifted the demand curve, then this stimulus may provide a source for saving that is not – in the short run – destructive.

Saving more is beneficial in the long run but if the savings rates increases so quickly that the economy can not adjust and the banking system is hobbled so it can’t intermediate that savings a downward spiral of economic activity may ensue. Will the stimulus package save us from a hard recession? No, we are already in one which will likely continue to hurt throughout 2009 and a recover is likely to be L shaped throughout 2010/2011. At that point hopefully HH (household) balance sheets and confidence have been repaired and the banking system is healthy enough (this is essential) that a private demand driven economy can return to steer the boat.

Krugman vs Hayek and the Cycle

The whys of the business cycle are complicated and fairly contentious – at least among economist. I don’t think we have a fully encapsulating explanatory theory but I tend to favor the Austrian Theory. Simply put that the cycle is driven my mal-investment (read: when expectations are off). The theory in a narrow sense argues that this poor investment is driven my non market (read central bank) driven monetary policy. If they hold rates to low a investment boom ensues which eventually, once the credit growth can no longer grow (we can’t leverage to infinity), credit slows and those poor investments fail. I have a small addition that I typical like to argue. Poor investment can be driven by over stimulative monetary policy (which provides low rate but also – and this is important – makes the environment less volatile) but they are more often driven by the inability of entrepreneurs and investors to see the future. So everything from disillusion expectations (IT investment) to shock to the economy (oil and gas in 80s) to innovation (investment in typewriter manufacturing capacity) can spark a transitional downturn where the old capacity is taken off line (which it should be because it is no longer valuable) and savings and investments build up new capacity. Monetary policy can dampen and extentuate the cycle and fiscal policy can help break downward spiral due to the paradox of thrift but until we can see the future the cycle will remain in one form or another. We can prepare ourselves for it and handle it better or worse but it is not going away.

I called this Krugman vs Hayek because I ran across an articleby Krugman where he attacked (something he enjoys doing) Hayek. His argument is that Austrians are taking the bleed the system approach advocated by Andrew Mellon at the start of the great depression.  He seems to suggest that ever letting productive capacity lay idle is a economic waste. I’m somewhere Mellon and Krugman in between and take a more nuanced view of the economic cycle. Letting the system bleed if it is entering a downward self perpetuating (deflationary/money supply contracting) spiral is a bad idea. The liberal capitalistic (Hayekian) system requires a functioning, as Smith put it, ‘civil’ society this requires that the bleeding not break the system. But on the other hand Krugman is wrong that leaving capacity idle is always a bad thing (he assume that we can tell which is productive and which is not). At the extreme if we keep capacity going we’d still be making typewriters and buggy whips instead of autos and computers. We have to let the system work through capital allocation decision because if we don’t the economy will become increasingly nationalized as no one want to buy the products that are produced and the government has to take over the unprofitable typewriter factories. Never letting Schumpeter’s forces of creative destruction function is a bad idea.

Now we are working off excess investment in housing but also have entered into an deflationary spiral and forces assets sales. So as I’ve argued before the fiscal stimulus – of the right size and form – is a good thing, but of the wrong size – too big or too small and of the wrong flavor – will hurt us both in the long and short run.  We have to tear the muscle so that it can rebuild but just not bleed the system white.

Auto Production ala 1920

Not much commentary here just a chart after looking at the industrial production – auto numbers.  A picture is worth a 1000 words (or I’m just being lazy).

Note: I believe that this is primarly driven by investory adjustment not a shift in demand so it should snapback but it is fairly extreme.

When was the last time it was this bad?   To be honest I’m not sure if cars were a normal consumer good in 1924, I don’t think so but I’m fairly sure it wasn’t a two or three cars per household era. 

No Capitulation on 2010 or at least not yet

The Fed minutes have chart that I like showing the distribution of projection about economic stats and how they have changed.  Basically the story is that the projectors have capitulated on 2009 being an unmitigated disaster but have not capitulated for 2010 (yet).

Hard to see look here.

The story over the past few months has not only been one of deterioration but of economic surprises on the downside.  Chance for stabilization will increase when expectations and policy get in front of instead of behind reality.

Are The Household Sunk?

In a crisis the lender of last resort has to make the choice to provide liquidity in order to stem unnecessarily default or to withhold capital that is only going to allow some creditors to get away before the entity fails. If an entity is really sunk it should be let to fail but if it is floundering because of liquidity problems than it should be assisted. So is the HH (household) sector so indebted that it would be better to let them collapse and then rebuild or are they just suffering due to a credit contraction (thus failure would be a unneeded cost). The most popular picture of the it going to be a long and painful bleeding out/failure crowd is below:

This is somewhat persuasive. I would make some adjustment (1) take out financial debt – it causes a lot of double counting, although leverage in the financial sector – as we all know – can lead to problem. (2) Show the chart without Government Debt; an apples to apples comparison is hard between HH and a reserve currency government. This would leave you with corporates and households; which are the two big players (HH being the biggest) in our economy. Let look more closely at the HH debt picture; debt as a % of GDP increased from about 70% to 100% of GDP between 1999 and 2007, but it is very hard to know – really know – how bad off the HHs are just by looking at that number. Where did the debt go? What is the servicing cost? Who owes the debt? How close are groups to failure? (Distributions Matter!)

This is where our friendly SCF (Survey of Consumer Finance) comes in. It slices and dices the household sectors balance sheet into geographic, occupational, ethnic, family structure, income, net worth, age, urbanity, working status, housing status, and education. Now some of these categories are more geared for social commentary and are not particularly useful for this discussion but the breakdown of the balance sheet by net worth (and its form) and income is insightful. Consider the follow set of charts:

(Hints on reading the charts.  Units on left are in thousands of real dollars (2007) or the described ratio.  The lines represent the different sections of the populations.  So <20%, represents the bottom 20% of households). 

First Off what does HH income look like:

Next what does HH net worth look like:

Next what does the HH Leverage (Debt/Assets) look like:

(note: I’ve scaled this so you can’t see the <25% group.  Essentially they have no assets so they have a very high leverage ratio). 

Lastly what does the HH debt burden look like:

All in all HH are more leveraged than they have in the past (and considering the continued deterioration since Oct 08 in assets prices some of these picture would look worse…although much of those losses will have accrued to the wealthiest sector) but do they look like they are sunk, probably not. (Note: The past due improvement have likley all gone away of late). I suspect the approach of putting the banking sector back together and allowing deleveraging in HH to occur over 5 years is the right strategy (rather than allowing for mass defaults); this is based on the HH not being beyond repair.

Who is extending and who is contracting credit?

So who, in the narrow proximate sense, is responsible for the credit contraction? Politicians like to blame the banks and say that they should be extending credit (what did you do with the money). The Treasury Secretary brought up the debt market (securitization) as a culprit. Looking at the data we can see, in a sense, which is responsible.

Consumer credit is still growing although at a very slow rate and banks are contributing more than 100% in the most recent report. They have had to make up for contractions from the securitization markets. It is interesting to note that as compared to the last time that banks had a capital crisis (91) they are loaning more freely (at least in the consumer credit side-consumer credit).

The mortgage market doesn’t paint as flattering a picture for the banks. In fact banks are contracting credit in the home mortgage sector (see www.cfg.org/cgs). In fact the only entity that is holding (using the term loosely) the ship tighter is the Government (read agencies). They held the whole thing together in the fourth quarter of 2007 and mortgage credit continued to growth a typical rate. Whether this was done explicitly or they simply took on business as it came to them is not something I know but the fact that they started to slow credit growth in early 2008 illustrates one of the challenges of having a pseudo-private entity that is trying to serve both its shareholder and a policy objective. The GSEs capitulation, explicit or implicit, in terms of sustaining something even close to the prior level of home mortgage credit growth lines up rather well with the collapse of the housing market. In affect the agencies capitulated (slowed credit growth) in an attempt to survive but in doing ensure their own collapse and in short order had to be rescued by the treasury.

This rescue essentially zeroed out both the common and preferred equity which is important because it may explain – in part – the dramatic fall in bank driven home mortgage credit growth in the third quarter. The commercial banking sector, which holds 69% of the bank sector home mortgages and 20% of total home mortgages, actually expanding credit in the third quarter. The contraction was due to a 5.4% of GDP annualized decrease coming from saving institutions (read thrifts). One could speculate that this is due to the harsh capital shock that a number of thrift took due to the preferred equity being subordinated in the rescue plan? This is hard to know for sure particularly when one tries to consider the impact that events like WaMu’s receivership would have on the data but it is something to consider. I think it is fair to point out that if as a result of a financial market bailout you are going to inject billions in loses into the financial markets you should consider where those loses will land and what it will do to the entities. (Note: Yes the banking sector realized gain from the agency rally but that was reasonably short lived and I doubt the small time thrift CEO perceives gains on the AFS securities the same as losses on what he had thought was capital – and received beneficial risk weighting). It is interesting to note that banks are behaving in a similar way to 90/91 but because of the level of credit growth was much higher it was implausible that the GSEs could hold the system over while the banks deleveraged, as they did in the early 90s.

The overall pictures gives one the feeling of an emerging market economy that has loss access to capital markets and is scrambling to find the cash to prevent defaults and capital to slow the forced selling which is pushing assets prices down (and arrest the downward spiral). The challenge from the lender of last resort perspective (typically the IMF in the EM case and Fed in the US domestic case) is when to lend and when to let a country/firm/household fail (a function of it is a liquidity problem or not). This question is only simply with the benefit of hindsight and thus at the time never simple (even if it is clear that the entity is bankrupt the question of it secondary affect – think Lehman – are hard to know). The Fed has chosen to try to extend liquidity suggest that it perceives much of the crisis as a liquidity driven crisis, or at a minimum that it considers the costs of extending the credit as less detrimental than not doing so. The Fed has extended massive amounts of credit: 2.3 trillion in the 3^rd quarter on an annualized basis (nearly 17% of GDP), although its growth has slowed of late, this has helped avert many problems. Much of the liquidity has tried to facilitate indirectly the intermediation process (repo lines, discount window, TAF, and internationally through swap lines), but when the banking system is impaired by a capital crisis it is unlikely they will perform the need intermediary role. Thus the fed, has wisely, stepped in and become the banking system directly (eg. commercial paper facility, buying mortgage assets).

The financial stability plan tries to step up the process by both direct intermediation and increasing the capital (or capacity) in the system to make the old pipes work. [Note: congressional demand to pay back the TARP money now, changes the calculus for the bankers. If the TARP I capital isn't capital but a pay it back soon loan of duress they will not use it as capital and the capital crisis will go on for longer. In fact they should not be allowed to pay it back until the credit channel is working and they have a large amount of excess capital; they shouldn't be allowed to pay dividends or buyback stock either].

Whether we have the capital/liquidity in order to save the system or whether the problem is too big and we are only delaying and changing the form of a collapse latter on is something we will have to wait and see.

Does Credit Matter?

A somewhat vague overview of the financial stability plan was given by Timothy Geithner last Tuesday. One sentiment that was used in the Secretary’s speech was the connection between a functioning banking system and a working economy. This connection is conceptually clear to most people. If you can’t get a loan to go to school, buy a car or house or some consumer good, you are more likely to delay or go without the consumption or investment. If you delay the spending, someone’s income goes down (whoever would have sold the service or good). When shifts in consumption happens in a typical environment it is the capitalist system in action – allocating resources and moving behavior via the price signal- but when it happens due to a breakdown in intermediation between savers and borrowers and as a result a shock in demand, the retrenchment is so violent that it can become a crippling self perpetuating spiral. When the demand for saving, in this case driven by a desire to deleverage, is so widespread and violent you can end up in a world where incomes fall so rapidly that savings falls as well (the paradox of thrift). Although the downward spiral hasn’t trigger that paradox in full it has triggered it to an extent and made the argument for a fiscal stimulus, in a sense as a non destructive supplier of savings, which can smooth out the delivering process and arrest the spiral persuasive. So that was the story in a nutshell and the conceptual connection between credit and the real economy makes sense but what does the data show us?

First consider the consensus proximate cause of the crisis, real estate, and its connection to the crisis. If you look at the Fed’s Flow of Funds and compare the growth in mortgage credit to the appreciation in housing prices you will find a tight correlation. The quarterly correlation since 1980 is over 60%. This suggests some sort of relationship between the two things. Admittedly correlation is not causation but the story makes sense. As credit eased and more money was pushed into the housing market home prices were pushed up at an increasing rate. One fact that is not revealed in total credit growth is the composition of that credit, consider that as home price appreciation was reaching its peak, private securitizations has essentially crowded out a government subsided portion of the credit market. They had not crowded them out in the sense of lower rates but in a qualitative sense (no money down, no income, ….). A valid question about this story could be that ‘did mortgage home prices appreciation increase credit or did credit increase home prices?’ Likely a bit of both; as home price appreciation accelerated more people had the capacity to use their home as an ATM and take out a home equity loan. Cash-out refinances average 37.2 Billion between 1991 and 2000 and 152.7 Billion between 2001and 2005 (see study). So the correlation between the credit driving home prices may be lower than is suggested by history but the connection is persuasive evidence that credit matters. As credit started to contract, at first qualitative tighten due to less securitization then quantitatively, home price appreciation collapsed eventually leading to outright home price depreciation. This led to the capital impairment which broke the banking system. (See the enhanced chart)

While the story of credit matters is clear for large ticket items such as housing – very few of us are going to buy a house without some form of credit – what about less credit heavy markets like autos? If you compare the auto securitization market and auto sales, a similarly compelling picture emerges.

I speculate that the lag is due to the nature of the auto finance business. A loan is made and a car is sold then they are packaged and sold. Thus unless the slowdown in the loan market is perceived as permanent (a dire view which I suspect, at the time, few had), the middle men would use their balance sheet capacity to smooth over securitization issuance volatility by taking on the auto loans. Of course they would eventually run out of capital and have to cut off the loan, and then the auto sales would fall dramatically.

What about a less credit dependant market such as consumer sales? On a headline basis, the correlation is weak but still positive (even more positive on a month over month basis). It is clear that consumer credit is not the only source of retail spending (remember mortgage equity withdrawal, wealth affect, unemployment/personal income are important factors in this picture) but that being said even headline consumer credit in it ugly raw form still correlates.

So now that I’ve taken a look at the data that illustrates the connection between credit and the real economy I have a more persuasive case that the getting credit started again will help fix the economy. But to understand how to get credit creation started one needs to understand where credit was coming from (as well as the concepts of balance sheet capacity both of the financial system and the household sector). So who is contracting credit?