Monday, October 23, 2017

The Upside Down CAPM and Lawrence Summers

I think there is a lot of value in turning the CAPM upside down.

Normally, we think of it as:  ER = R(f) + B*ERP

The expected return of the broader stock market is the risk free rate of return plus the equity risk premium - the premium investors demand for having exposure to cash flow that is volatile over the business cycle.  The expected return on a given equity is its "beta" - its sensitivity to broader market volatility.  The broader market, by definition, has a beta of 1.

I prefer to think of equity market expected returns this way:  R(f) = ER - ERP

It's a simple algebraic reformulation, so it seems like it can't make that much difference.  But, the key is that (1) expected returns (ER) seem to be pretty noisy (or unknowable) around a stable mean, so that ER can generally treated as a sort of mysterious constant and (2) the real risk free rate is generally negatively correlated with expected real growth and does not have a stable mean.

When secular growth expectations decline, R(f) tends to decline and ERP tends to rise.  Expected returns aren't a product of R(f).  It's more accurate to say that ERP is a product of R(f), so that, lower growth expectations cause equity holders to demand higher returns relative to R(f).  Comparing equity yields to real bond yields gives us little information, and comparing equity yields to nominal bond yields is less than useless.  (We are currently in an odd time, because what amounts to financial repression in mortgage markets has pushed real long term interest rates lower than what we might call broadly the "natural" rate.)

I was recently listening to Lawrence Summers on David Beckworth's great podcast series.  Here, I think Summers has presented an example where this framing would help.  He is talking about whether it would be beneficial now to have a US sovereign wealth fund investing in equities:
If it were all about risk premiums then you'd think this was a particularly attractive moment to invest in stocks relative to bonds because there was an extraordinarily high risk premium . I think most sophisticated people in markets kind of think the opposite. Some people think the stock market's a bubble, some people think it's not. I don't know many people who think it's unusually cheap, which would be the corollary of the view that the risk premium is extremely high. So I don't particularly relate to the safe asset paradigm. If you had that paradigm, then you would say that if the spread between bond yield and stock yields was super wide. This was a good moment for the government to issue bonds and buy stocks. But I don't find that a plausible guide to my own investment behavior. And so I'd be hesitant to inflict it on the government.
Now, in ERP terms, clearly there is a high equity risk premium.  Clearly, expected returns on equity are much higher than risk free returns.  Summers is speaking about risk premiums, but he seems to be thinking in terms of absolute valuations.

If equities perform poorly, though, it will be the result of unforeseen real income shocks.  It will have little to do with valuations, because valuations, in terms of total expected returns, don't actually change that much after taking account of cyclical changes in growth expectations.  Thinking of equity valuations as a fairly stable long term variable with a lot of short term and mid-term variability, then it is much less confusing.  Clearly the equity risk premium is high, and we don't need to know much more than that real long term interest rates are low to realize that.  After cyclical adjustments (which are large for equities, make no mistake), it will take some sort of epic regime shift in the American economy to keep equities from vastly outperforming real bonds over the next 30 years or so.


Later in the interview, a couple of other items caught my attention.  On QE:
I'd also say, whatever you thought a few years ago, fact that we stopped QE and interest rates kept falling, it has to lead you to think QE is less effective than whatever you thought before we did that experiment.
This comes from thinking of monetary policy through interest rates.  Clearly, to me, the fact that interest rates fell after the QEs were ended is a sign of how QE was effective and had kept rates from falling while QE was on.

But, then, he follows up with this comment about raising rates moving forward:
And I don't see the financial stability rationale either. I'm not sure that markets are extraordinarily overvalued. If I believed with confidence that markets were a bubble, I'm not sure that would be a reason to tighten policy. It might be a reason to ease policy. 'Cause when the bubble bursts, we're gonna have a real problem. And so, I might as well get some stimulus into... Behind the economy. So, I don't see the case for tightening.
Can I nominate Summers for Fed chair in 2006?

Thursday, October 19, 2017

Housing: Part 264 - Rent is how we consume housing services!

Chris Dillow at Stumbling and Mumbling has a post up about housing where he claims that added supply in London won't make housing much more affordable.

This post is an excellent example of how confusion between owning and consuming is such an important source of error in housing markets.  To be fair, his treatment of the issue is conventional here.  As he writes: "Changes to the flow of the asset are generally too small to have much effect. For this reason, many economists have traditionally modeled house prices as if only demand matters".

This is absolutely, sadly, true.  As with his post, pick up any random academic article about the causes of the housing bubble and it is likely that "rent" is not mentioned in the paper at all, even as a factor to be dismissed.  It is widely treated as a factor not relevant enough to even bother dismissing it.  Not only is housing treated as if only demand matters, but it is treated as if this is demand for owning, rather than demand for consuming.

I wonder if the single most useful policy we could enact regarding housing markets would be to force all homeowners to actually write themselves a check each month for the market rental value of their homes.  I think the fact that we don't do this, so that many homeowners equate their cash expenses with the cost of housing, is a significant reason why this error is so widely committed.

The cost of housing is rent.  Period.  The crazy thing is that about half of the residents of the large urban centers are renters!  For them, this is not complicated.

Dillow writes:
If supply doesn’t affect prices, what does? Lots of things: demographics, incomes, debt levels, expected incomes and the availability of credit. My chart shows another influence: real interest rates.
Now, in order for interest rates to affect home prices, rental value must be an input, as Dillow's chart implies.  But, by removing rent as an explicit input, notice how much easier it becomes to dismiss supply as a factor in price.  Supply won't affect any of the remaining factors Dillow cites.

Imagine if we conceived of other markets the way we conceive of housing.
Families are finding it increasingly difficult to feed their families.  But, the proposed solution - to harvest more grain - is a non-starter.  There is only so much land, and adding to the available acreage is a slow process that can't begin to keep up with the problem.  And, acreage continues to be very expensive.
Acreage is expensive mostly because of low interest rates, loose lending to farmers, and high farmer incomes.  So, the question is, how do we reduce the value of acreage to make food more affordable?  Maybe we could pass laws so that farmers must allow gleaning.  Maybe we can put more obstacles up so that banks aren't so eager to lend to local farmers.  Maybe we can regulate the harvest so that farmers only sow the grains that we have determined are most in need.

PS. It could be that Dillow's claim about supply not bringing down prices is somewhat accurate in practice, which I discuss here.  It depends on whether high prices in constrained cities are more sensitive to interest rates or to expectations of rising rents.  If constrained supply makes prices more sensitive to low interest rates, then the rate of new supply in the worst cities would, indeed, need to double, triple or more in order to stop the flow of low-income out-migration and to introduce enough supply to create a regime shift in rent expectations so that they are actually expected to decline.  I have been moving toward this point of view.

Wednesday, October 18, 2017

Housing: Part 263 - The correct answer is not in the set of choices.

Actual footage of economists answering IGM Questions
The IGM forum polled  economists about Factors Contributing to the 2008 Global Financial Crisis.

In order of importance, the choices are:

  1. Flawed financial sector
  2. Underestimated risks
  3. Mortgages: Fraud and bad incentives
  4. Funding runs
  5. Rating agency failures
  6. Housing price beliefs
  7. Household debt levels
  8. Too-big-to-fail beliefs
  9. Government subsidies: Mortgages, home owning
  10. Savings and investment imbalances
  11. Loose monetary policy
  12. Fair-value accounting

Some of these are actual problems, or at least policies which are arguably not optimal and feed instability.  Numbers 1, 2, 4, 5, 8, and 12 are basically issues that will always be up for debate and that will always appear, in hindsight, to be the cause of financial crises.  When there is a run up in defaults or a run on assets at financial intermediaries, for any reason, in hindsight, it will appear wise to suggest that financial intermediaries took too much risk, held too few assets, or underestimated risk, and balance sheet accounting that forces pro-cyclical buying and selling will make those things worse.  All of these things could possibly be addressed to help avoid future instability, and they certainly count as contributing factors, as posed in the question.  But, they don't really help much in terms of finding foundational causes of a financial crisis that occurs after national real estate markets have lost a quarter or more of their nominal value.  In the respondents' defense, the question was about "Factors Contributing to the 2008 Global Financial Crisis", so these answers aren't wrong regarding the question at hand.

Numbers 3, 7, and 10 are outcomes of the bloated housing market.  These outcomes are the result of bloated asset values, regardless of the cause of the bloat.  Again, as "factors contributing" to the crisis, they aren't necessarily wrong.

Number 9 legitimately contributes to the capitalization of real estate asset values, and thus higher prices, and also contributed to price volatility, though in a way that I don't think is widely appreciated.

The problem is in the list of questions.  In all of these cases, there is a presumption that the cause of both the boom and bust was the financial sector.  And, there is a presumption that the bust was inevitable.  Some of the respondents note that some of these factors are mechanisms or effects more than causes.  Of 74 respondents, only one noted that the list was tilted toward issues in the financial sector, but even that respondent, Nicholas Bloom of Stanford, makes clear that he considers home prices to have been too high, presumably making the bust inevitable.

Numbers 6 and 11 reflect the confusion that comes from the presumptions behind the rest of the list.  Loose monetary policy is given low importance, which is heartening.  What is interesting about that is that tight monetary policy isn't even presented as a potential cause, and none of the respondents seem to have a problem with that.

That leaves Housing Price Beliefs.  This one little factor in the heart of the list.  The rest of the factors really hinge on this factor.  Surely, limiting ourselves to this list of potential factors, none of the other factors would have been notable if we hadn't started with the core problem of overpriced housing that was bound to collapse.

Here, I present a series of scatterplots.  Each point represents the median home price of a given metropolitan area.  The x-axis is the price at the beginning of the time period.  The y-axis is the change in price over the given time period.

The graph these economists appear to have in mind is the first graph, of home prices from 2006 to 2011.  During the specific period of the crisis, there was a clear negative correlation between home prices and subsequent changes in home prices.

This period of time does appear to suggest that beliefs about home prices were optimistic.  It was also characterized early by an inverted yield curve, which is a broadly accepted sign of tight monetary policy, followed by a collapse in investment and GDP growth, a rise in unemployment, and a persistently low rate of inflation - also all signals of tight monetary policy.  It was also characterized by a near nationalization of the mortgage market and probably the single most extreme publicly imposed tightening of credit standards in US history.  Also, not available as an option on the poll.

Regarding those home price expectations and credit standards, we might take a step back and look at the broader picture.  What if we step all the way back to 1998 and all the way forward to today?  I think that it can be stated uncontroversially that, regardless of how one regards credit standards in 2006, in the time since then standards have remained tight - tighter than in any recent period of time.  After all, the private securitization market that funded subprime and Alt-A loans is basically non-existent.  So, I hope we can agree that home prices in 2017 are not part of a credit-fueled housing bubble.  Surely, collapsing rates of homeownership and a decade-long period of depression level residential investment are confirmations of this fact, if confirmation is required.

So, how about price expectations of home buyers back in 1998?  How did buyer expectations pan out?  In this case, there is a strong positive correlation between starting price and subsequent price growth.  Keep in mind, this period of time includes the period shown above.  This period of time concludes with a decade of public policy explicitly aimed at limiting access to mortgage credit where real estate is expensive, keeping home prices low.  Yet, for each 10% premium homebuyers paid in 1998, they could expect to earn about 4% in additional profit over the next 19 years.

This isn't just a refutation of the idea that price expectations were too optimistic.  In high priced markets in 1998, home price expectations were extremely pessimistic.

Now, let's move up in time, to the peak of the boom at the end of 2006.  Here is the scatterplot of home prices and subsequent changes from then until today.  Remember, again, during this period of time there was an extreme directional shift of tightening mortgage credit market standards that included the collapse of an entire conduit for mortgage originations.  In fact, today, total mortgages outstanding have still not grown to a higher level than they were at the end of 2006.

There is a bit of a V-shape here, because the Contagion cities, which tend to fall in the middle of the valuation range, did experience a bit of a bubble and bust as a result of the housing refugees fleeing the expensive cities, which I have addressed at length.  But, the notable thing here is that there is little relationship between home prices in 2006 and subsequent price changes, between MSAs.  A $690,000 home in San Francisco gained about the same as a $130,000 home in Lincoln, Nebraska.

The difference, overwhelmingly, between 1998 and 2006 is that price expectations in 2006 appear to be much more accurate across MSAs than they were in 1998, because home prices in the highest priced MSAs had been finally bid up to levels that would make future price gains insensitive to the starting price.

Maybe the 30% lag in relative valuations among those mid-range cities is the tell-tale sign of a generation defining bubble?  Then, what does that say about the 100%+ gap in relative valuation shifts after 1998?  Can someone please point me to the section in the library with 50 books explaining how extremely underpriced housing in coastal cities was in 1998?  Or, maybe price expectations in every city were too optimistic in 2006.  Maybe the $130,000 buyer in Lincoln was just as blinkered by optimism at a Price/Rent ratio of 14x as the $690,000 buyer in San Francisco was at a Price/Rent ratio of 28x?

Or maybe, none of this was inevitable.  It is a shame that tightening credit standards and tight monetary policy were not available as choices.  A few respondents did apply a low score to price beliefs and monetary policy.  I count 6 from the US panel and 9 from the European panel that gave both a score of 2 or less, on a scale from 0 to 5.

Robert Hall of Stanford and Chair of the NBER Business Cycle Dating Committee applied a 1 to loose money, home price beliefs, debt levels, underestimated risks, fraud, and savings and investment levels. (He gave himself a confidence score of 1.)  On the European panel, Lucrezia Reichlin of the London Business School gave monetary policy a 0 and price beliefs a 1, with a confidence of 8. Richard Portes of the London Business School gave them a 0 and a 2, and noted that not being the lender of last resort for Lehman would get a 4, with a confidence of 9.  Per Krussell at Stockholm University and Rachel Griffith at the University of Manchester gave both a 1.

I wonder what these respondents would have answered to the missing questions.  The correct understanding of the financial crisis lies outside the Overton Window.  The correct answer to the poll was not an option.  Would any of these respondents have given tight money or tightening credit a high score?  We can't know if we don't ask them.  I suppose that's why the question has been left for a doofus like me to answer.  Not that anyone asked.

Tuesday, October 17, 2017

Housing: Part 262 - Self-fulfilling prophecies are highly reliable.

From Calculated Risk:

"Usually near the end of a recession, residential investment picks up as the Fed lowers interest rates. This leads to job creation and also household formation - and that leads to even more demand for housing units - and more jobs, and more households - a virtuous cycle that usually helps the economy recover.

However, following the 2007 recession, with the huge overhang of existing housing units, this key sector didn't participate for a few years."

I'm sure I'm a broken record on this, but it really is amazing how much power our priors have in what seem to us to be empirically derived conclusions.

If the overhang of existing housing units was inevitable, then the protracted recession was inevitable, and there was nothing to be done.  If the overhang of existing homes was a result of our resignation to contraction, and, in fact, our insistence upon it, then the protracted recession was collective self-immolation.

The existence of unsold inventory in 2007 or 2008 tells us nothing about which of those interpretations is correct.

There were millions of willing buyers for that inventory, and those willing buyers ran headlong into a national obsession with preventing them from doing so.  Would allowing that to happen have been a self-fulfilling prophecy, too?  Sure.  The fact that this nation overwhelmingly approves of the self-fulfilling prophecy we chose, even as it bankrupted so many of us, threw workers into unemployment, and destroyed the balance sheets of many young and middle class homeowners tells us just about everything we need to know about the mystery of our ailing economy.

The American populace, paraphrasing "A Few Good Men", barks, "Economic stability?! You can't handle economic stability!"

Sunday, October 15, 2017

Sentiment is counter-cyclical. Policy views are pro-cyclical

I thought this was an interesting and telling chart.  And it is a nice piece of evidence against the various macroeconomic theories that are built on the idea that pro-cyclical investor sentiment drives business cycles.

This sure looks like counter-cyclical sentiment to me.

This is related to another great chart that I recently came across.  Sentiment had turned south in the housing market well before 2004.

This counter-cyclical sentiment is, I believe, the reason why we have macroeconomic theories that project a pro-cyclical sentiment.  If sentiment in some group is counter-cyclical, then that group will be convinced that their aggregate sentiment is pro-cyclical.  This is why I am only slightly flippant when I suggest that a reasonable monetary policy rule would be to conduct surveys about what policy shift is most favorable, and then do the opposite.

Think about it.  The reason that it seems like housing markets were out of line in 2005 is because practically everyone knew that prices were too high, yet prices kept rising.  When prices kept rising, lo and behold, there were buyers and sellers who were thumbing their noses at our communal sentiment.  There were even some buyers who were pretty excited about it.

Now, there were certainly some types of buyers and some types of speculators who were more active in the market than usual, at the time.  But, our perception of those buyers is skewed by our counter-cyclical perceptions.  Consider that the housing stock is pretty stable.  We don't suddenly double the number of units in a bull market.  And, think about all the anecdotes from 2005.  Small time speculators who owned a half dozen homes in the sand states.  Janitors in California talked into buying a home with a mortgage that would claim 90% of their take-home pay.  Etc.  Add up all the buyers in your mind.  Think about the fact that for that small time speculator, there had to have been a half dozen former homeowners who sold their homes to the speculator.  There are only so many homes to be owned at any time, with only marginal changes, so those homes had to be bought from someone.

How many articles were in periodicals at the time about all the former homeowners who exited the market?  How many books line the shelves at your local library about how many former homeowners sold out in 2005 or 2006?  For every na├»ve speculator with a half dozen leveraged homes there must have been several.

Our point of view controls these perceptions as much as facts do, and our point of view is counter-cyclical.  We really notice when market activity betrays our point of view.

We can see this in the stock market in the image above.  As prices rise, sentiment sours.  Yet, the price keeps rising.  How can that be?  It's because price is surprisingly immune to sentiment.  Markets take in a huge amount of primary, secondary, and tertiary investor activity and input.  Market participants may not bid up stock prices because they are in a speculative mood.  Maybe, they bid up prices because prices are cheap, in spite of sentiment, and that fact is manifest in prices, even though our primary market sentiment is weak.

How do we reconcile the chart above with the growing number of anecdotes like this one?


Uber driver in OC says she and husband were in real estate, lost all in 2008. Only now venturing back into "investment real estate." Hmm.
— Bethany McLean (@bethanymac12) October 14, 2017


Do the 4% of potential investors who are feeling bullish and speculative all happen to be Uber drivers and such, or does our counter-cyclical sentiment cause these anecdotes to become more palpable when we are bearish?

We interpret our perceptions as a confirmation of pro-cyclical sentiment.  But, in reality, prices are not particularly sensitive to sentiment.  Intrinsic value of assets is more stable than our sentiment is, but we treat our perception as fixed and we dismiss the efficiency of markets.  So, as our sentiment swings above and below the market, as it generally follows intrinsic value with some small amount of deviation, we come to a conclusion about prices that is the opposite of reality.

And, what is the result?  Where we have the ability and resolve to impose our "theory by attribution error" * on markets, we impose cyclical instability.  When sentiment is bearish, we become convinced that stubbornly bullish sentiment is pushing prices too high, and we demand policies that will dampen economic activity.  When sentiment is bearish, policy becomes bearish, and our sentiments are confirmed.


This survey data appears to contradict the data in the above tweet, and suggests that investors expect gains, even though they don't personally think the market is undervalued.  This could be due to speculative fervor, or it could be a realistic expectation of rising real production that causes values to increase along with economic growth.  Even in this survey, the average respondent's expectation is for something just under 5% for the quarter, with a negative skew.  That doesn't seem particularly unreasonable.  But, the negative skew of expectations has definitely declined over the past year.

* "We" base our personal point of view on an assessment of market conditions, the business cycle, and hard earned wisdom.  "Others" are creatures of fear and greed, chasing after every trend.

Friday, October 13, 2017

September 2017 CPI

We continue in a holding pattern.  YOY core inflation is about 1.7%, core inflation ex. shelter remains about 0.6%.  Shelter inflation continues to remain above 3%.  There hasn't been a single month of core ex. shelter inflation above 0.1% since February.

Mortgage growth and bank lending seems to be growing at a rate of 2-3%.  I suppose things could just keep moving ahead indefinitely like this.  But, I think the obsession with asset prices and the tendency toward viewing asset prices as a reason for tighter monetary policy will prevent us from easing when random economic shifts cause a downshift in these patterns when there is no buffer for a downshift.

Thursday, October 12, 2017

Housing: Part 261 - comparing three markets

This graph compares median home prices in Phoenix, LA, and New York City to the median US home price.  Briefly reviewing these three prices can give us a quick summary of what happened during the housing bubble and what might not have happened, in spite of our initial conclusions.

Let's start with New York City.  In 1997, New York City was already pretty expensive, but it got even more expensive in the years that followed.  Eventually New York homes rose to more than twice the price of homes elsewhere.  Surely part of the bubble, it would seem.  But, strangely, even with the extremely tight lending markets of the decade since, New York homes have remained more than twice as expensive as homes elsewhere.

LA looks much like New York City before 2004, but prices there jumped as the privately securitized motgage market exploded.  Then prices came back toward New York prices when that market collapsed.  This suggests that collapse was disruptive.  So was the private mortgage market part of a housing bubble?  Seems clear. Except that, again, during tight lending markets LA home prices have not only remained twice as expensive as homes in other places, but they have moved back up to triple the typical home price.  This suggests that those prices don't require loose lending.

Phoenix prices jumped by nearly 50%, relative to the US and then quickly retreated. After briefly falling below the US median, the Phoenix median price has recovered back to about the US norm.  That looks like a bubble.  Up to about 10% of the US had housing markets that looked like this. All of those places have one thing in common.  At the time they were taking in thousands of migrants from cities like New York and LA looking for homes.  Those migrant flows usually amounted to 1% or more of local populations per year until they dried up in 2006.

Cities like Phoenix aren't even close to their capacity for building homes today. That is one necessary ingredient for a bubble - short term supply inelasticity.  What would happen today if lending was more generous? It would be interesting to find out.

Tuesday, October 10, 2017

Housing: Part 260 - The gorilla on the court

There is an old psychological test where subjects are told to count the number of times some basketball players pass a ball around.  During the test, a person in a gorilla suit waltzes through the middle of the players.  Only about half of the subjects even see the gorilla, because they are concentrating on the basketballs and their selective attention causes them to miss the gorilla even though it is right in the middle of the scene.

I feel like I am watching a nationwide re-enactment of that test when I see people talking about low-tier housing demand.  I have touched on this weird development previously.  The latest round has come from reactions to comments made by Svenja Gudell, chief economist at Zillow:
affordability – at least on paper – looks good, thanks largely to very low mortgage interest rates; and home prices themselves show no signs of declining any time soon. But on the ground, the situation is much different, especially for younger, first-time buyers and/or buyers of more modest means. Supply is low in general, but half of what is available to buy is priced in the top one-third of the market. This only stiffens competition at the entry and mid-level segments, which pushes prices up faster and actually contributes to quickly worsening affordability for these buyers.
This is a case of mistaking the symptoms for the cause.  But the root problem is because the actual cause is the gorilla on the court.  Everyone is on the lookout for predatory lending, overbuilding, a new bubble.  They have been on the lookout for those things for at least 15 years.  And, there was certainly a period of strong building, borrowing, flexible and destabilizing mortgage terms and funding mechanisms.  While everyone was counting up all those things, a gorilla walked through the court - tight monetary policy, shifting sentiment, and an extreme shift to very tight credit standards so that a large number of potential first time buyers aren't potential first time buyers anymore and many homeowners are stuck in homes that they once borrowed money to purchase with mortgages they would not qualify for today.

There is nearly unanimous support for a massive regime shift in lending standards, yet few understand what we have done.  Tight standards are prudent.  Right?  You're going to argue against that in the middle of a financial crisis?

The gorilla on the court is that there is little funding for entry level home buying.  So it seems like a big mystery.  This CNBC piece on Gudell's comments considers that maybe investors are the problem.  "Supply on the low end is tight because during the housing crash investors large and small bought hundreds of thousands of foreclosed properties and turned them into rentals."  So, why don't builders come in to meet that demand?  "Homebuilders are simply not building enough inexpensive houses that the market needs."
The homes are there, they're just not selling, and it's not hard to figure out why."The recent home sales data has reflected a slower pace and I continue to believe it's due to more a push back on pricing," wrote Peter Boockvar, chief market analyst with the Lindsey Group, in a response to the data release.
The article quotes Gudell, "What's missing from the equation is a lack of homes actually available to buy at a price point that's reasonable for most buyers." and concludes, "The trouble is, even though the market is woefully mismatched, home prices will not come down as long as there are some buyers out there willing and able to spend more and more money for less and less house."

Honestly, this is amazing.  I don't really fault the CNBC writer, or Gudell, or the others.  There is clearly a mass hypnosis going on here that is more powerful than the an individual's sense of logic.  What exactly do they think is keeping those rising prices from triggering new supply?  I'd like to sit down with the entire country, give them some Lego figures and Monopoly pieces and have them walk through this step by step.

Here are some people.  Here is a bank, some homes, and some potential homes.  Homes are extremely affordable for mortgaged buyers, especially at the low end of the market.  Walk me through how this breaks down.

But, they simply can't say that there isn't enough lending in that market.  The truth is too far outside the acceptable narrative.  That can't be a reason, and they are left with strange reasons, like homebuilders with inventory that doesn't match their customer base.

We limited access to ownership (and supply) compared to previous standards.  This means that returns rise for the remaining owners.  And, since we heap subsidies on the "haves" through the tax code, there are two distinct markets.  Top tier markets where the "haves" buy larger more expensive homes, and low tier markets where the "have nots" downsize as rents rise.

With all these "haves" and "have nots" it must be industry consolidation, or real estate investors, that are the problem.  All agree that we "solved" the problem of predatory lenders.

Here is a graph of real estate value as a proportion of GDP (scaled for comparison) and mortgage debt service.  Closed Access real estate is the toll booth to opportunity in the current economy, so its value will relentlessly rise.  That value (the red line) is the cost of holding a limited asset - the cost of preventing others from accessing opportunity.  It will continue to rise.  We have a sort of chimera free market/banana republic economy where only certain citizens have access to property.  That property provides economic rents to its owner.  In a banana republic, those rents come purely through income.  The market price of the property remains low because it is the lack of access to ownership that provides the rents.  You own the property because of who you are.

In our chimera economy, there is limited access property that provides economic rents to its owners.  But, its ownership isn't limited to who you are.  It is available to all, as long as you have the means to pay for it.  So, in our economy, the value of the property can fully account for its value as an obstruction preventing others from living in our gated metropolitan areas.

Before 2007, this was moderated by migration.  Those without means moved away from the Closed Access cities to less prosperous places.  Those with means, or at least with bright prospects, moved in, frequently financing the move with mortgage debt.

We have ratcheted up this process since 2007 - moving more into banana republic territory by severely limiting property ownership through mortgage regulation. So, now, prices of real estate are lower, because there are few potential buyers, especially among the "have nots", but the income and the economic rents that property pays out are higher than ever.

Here are Zillow's measures of rent and mortgage affordability.  But, this is really not even half the story.  Homes in low-tier markets have price/rent ratios much lower than homes in high-tier markets.  For marginal homebuyers who are the CFPB's "have nots" (for their own protection!), the difference between mortgage and rent affordability is huge.

Below is a graph I recently noticed in this great Griffin and Maturana paper.  Of all the work I have read, I think they do the best job of counting the passes of the basketball players, as it were.  Of all the "credit supply" school research, I think they make the most compelling case.  They frame the cause of some rising prices in terms of "dubious" mortgages - mortgages with poor documentation and false information.

This graph is of home prices in cities with elastic housing supply, what I would call "open access" cities.  In Closed Access cities, new mortgage access might cause prices to rise, because supply is limited.  But, in Open Access cities, it is hard for prices to rise far above the cost to build, so new credit is more likely to lead to new homes.

They find that prices in zip codes with dubious lenders didn't rise more than prices in other zip codes in the Open Access regions.  But, prices in the dubious zip codes did fall much farther after the bust.  They take this, understandably, as a sign that dubious mortgages induced oversupply, which led to a collapse.

This is an understandable conclusion because they can't see the gorilla.  As the others I quoted above have noted, rents have been increasing.  That is odd.  If prices were falling because of oversupply, you'd think you would see that in rents.  Griffin and Maturana follow the standard practice of academics arguing about the role of credit in the housing boom and bust.  The word "rent" does not appear in the paper.  (Well, it appears once regarding "economic rents", but not regarding rental income of a homeowner.)  So, it is understandable that they didn't notice that oddity.  Rent just isn't part of that conversation.

The graph is interesting because the initial shock affected both areas - those with more dubious lending and those with less.  By the third quarter of 2008, the mortgage origination industry that had grown up around private mortgage securitizations had been dead for some time.  There really are two distinct periods here where home prices fell more in the areas with dubious lending and diverged from the other areas.  The first was in the third quarter of 2008, when the financial crisis hit and the GSEs were taken over and lending tightened.  The second was after the third quarter of 2010, when Dodd-Frank passed.

The collapse in the bubble cities was of a scale so much larger than other areas, it sort of drowns out what was happening in the bulk of the country in 2008 and 2009.  But, here, where Griffin and Maturana have isolated the Open Access parts of the country, it looks like Dodd-Frank had more of an effect on these home prices than the GSE takeover did.

G&M look at the change in prices over the entire period after 2006, and conclude that when the dubious lenders collapsed those zip codes had a supply overhang because of all the unqualified homeowners, and that led to inevitable decline.

But, first, there never were too many homes.  Second, by 2010, when most of the divergence happened, homebuilding had been dead for years.  There is no way that the divergence that happened then was the result of supply overhang.

G&M counted all the passes.  But, the gorilla on the court is that after 2007 lending standards were tightened extensively.  G&M, like most people, seem to just account for any contraction after 2006 as if it is simply an unwinding.  But, the pendulum swung far in the other direction.

We can see here how, as is so often the case in this story, the presumption determines the conclusion.  G&M do a lot of interesting work in that paper.  But, some of their conclusions come down to an implicit presumption that whatever happened after the bust was inevitable and that lending norms at the end of the bust were roughly similar to lending norms that pre-dated the boom.  That presumption is incredibly wrong.

In fact, in their chart that I show above, if we were looking for gorillas, it would seem quite obvious to us that the discontinuity was in 2008 and after.  Let me be clear - it would seem obvious.  Maybe that presumption is wrong too.  I don't think it is wrong.  But, the change in presumptions so that we were looking for a time when credit standards tightened, would lead us to view that graph with high confidence as confirmation that in 2008 and after, there was a devastating collapse of marginal credit markets.  That's the gorilla.  Once you see the gorilla, you stop paying attention to the basketballs.  You say, "Holy cow! There's a gorilla on the basketball court!  That is something!"

This doesn't mean there weren't basketballs.  Surely some housing outcomes in 2004 and 2005 were facilitated by peculiar mortgage market developments.

But, Dude!  There's a gorilla on the court!

Friday, October 6, 2017

Foreign Direct Investment into US Rising

Here's an interesting post by Timothy Taylor.

He notes that foreign direct investment into the US has recently spiked.  Here is a graph from his post.

That is interesting.  The US has a longstanding pattern of investing in high-return direct investment in foreign economies.  Foreign investors into the US tend to invest in low risk/low return debt.  This is actually the main source of our trade deficit.

Think of it this way.  Take $1 billion of US foreign direct investment earning 6% returns and $2 billion of foreign investment in the US earning 3% returns - $60 million each.  Let's say that earnings are reinvested in both cases, with similar returns.  Next year, US investors abroad will earn $3.6 billion additional returns and foreign investors in the US will earn $1.8 billion.

Foreign investors must invest an additional $60 billion into the US in order to keep up with the growing US foreign income.  If they don't, then US foreign income will continue to climb.  In order to get those additional $60 billion, they export us goods and services and then they send those dollars back to the US as investments.

This is basically what has been happening over the past 20 or 30 years.

So, this is an interesting development.  We should expect that foreign earnings on US investment will grow.  And, this should also moderate the trade deficit.  (I mean to state that as a fact, not as some sort of normative hope.  We shouldn't be that concerned one way or the other.)  And, Taylor mentions that these tend to be export-intensive investments.  In other words, the operations funded by these investments tend to produce US exports.

All in all, I think this is generally a good sign, if only because it is a sign, finally, of a return to more at-risk investments and a possible decline in the equity risk premium.

Wednesday, October 4, 2017

The confusion between Quantitative Easing and Interest on Reserves

Arnold Kling has a link to some commentary on QE from economists at First Trust.  They question whether QE was effective.  I agree with some of their comments.  I do think the issues with mark-to-mark accounting and some of the other actions taken in spring 2009 did contribute to the turnaround.  But, I think we need to be careful about exactly how we identify Fed policies during that period.

The problem is that in October 2008, the Fed initiated interest on reserves in a strange and misguided attempt to keep the fed funds rate at 2% even though the Fed clearly should have been pumping cash into the economy, which would have pushed the fed funds rate lower.  For most of the next two months, the interest on reserves rate was actually higher than the effective federal funds rate even though it was lower than their stated target rate.  In other words, Fed policy was so tight at the time that they would have basically had to sell their entire remaining stock of treasuries to meet their target rate, sucking cash out of the economy.  They couldn't do that, so they used interest on reserves as a sort of back door way to obtain cash.  Instead of pulling currency out of the economy, they borrowed cash from the banks.  They induced banks to lend to them instead of lending into the economy.  They bought treasuries with that cash, so another way to describe what happened is that they induced banks to lend to the government instead of to private parties, and they acted as an intermediary, with excess reserves as the bridge between banks and treasuries.

This was a contractionary policy, and because they were acting as an intermediary between the banks and the treasury, the Fed's balance sheet ballooned.

Then, at the end of 2008, and later in 2010 and 2012, they did three rounds of quantitative easing.  Since by then rates were near zero, this meant that they injected cash into the economy without using the framing device of raising or lowering rates.  The use of interest rates as the framing device for describing monetary policy is strange anyway.  I wish they didn't do that.  Since the neutral rate is a moving target, it leads to a lot of misguided opinions about whether policy is loose or tight.  And, it causes the idea that monetary policy works by making cheap debt financing available to be greatly inflated in the minds of the public.  It seems that most of the commentary, even among financial experts, about monetary policy and the business cycle is framed that way, and I think that is very damaging.  It would be better to base financial analysis on astrology.  At least that would lead to an unbiased random outcome of analysis.  It's like the experiment where you put a moth and a fly in two separate open jars with the bottoms facing a light.  The putatively smarter moth keeps knocking himself against the bottom of the jar in an attempt to escape toward the light while the fly just flies around randomly until he escapes the jar.

Anyway, it is odd that QE is framed as some sort of new type of policy.  It was August 2007 to September 2008 where the Fed had a strange new policy.  They were making a series of emergency loans to failing financial firms, but they were "sterilizing" those loans by selling treasuries into the market, so that those emergency loans didn't cause currency to expand.  When the Fed initiated QE at the end of 2008, that was actually a return to normal monetary policy.  That was the first time in more than a year that they actually just bought some treasuries in open market operations with the motive of injecting cash into the economy in order to create inflation.

This was an accommodative policy, and because interest rates were near zero, the incentive of private institutions to avoid holding cash was low, that cash was simply held at banks, and the Fed's balance sheet ballooned.

We can see these effects in this Fred graph of the Fed balance sheet and 5 year inflation expectations.  In late 2008, inflation expectations cratered when interest on reserves was initiated.  Policy was highly contractionary and the balance sheet bloated.

For the first part of QE1, the balance sheet didn't actually expand, because while QE1 was expanding the balance sheet, the initial surge of excess reserves when the Fed pegged the short term rate target at 2% was now unwinding, since the rate was near zero.  By mid 2009, QE1 was growing the balance sheet.

Then QE1 was ended, but QE2 began in late 2010, and we see the balance sheet grow again.

Now, to me, just eyeballing inflation expectations, I see expected inflation rise as the initial interest on reserves policy gives way to QE1.  Then, it recedes after QE1 ends, then it rises again when QE2 begins, and recedes again as QE2 ends.  There is little reaction to QE3, but when QE3 ends, inflation expectations again recede.  The QEs seem to be weakly effective.

I have also included the nominal 10 year treasury rate in the graph.  It gives a more clear signal with the QEs, rising each time and declining after they end - even during QE3.  Each time, there is a little hump in 10 year rates.  This is an example of how thinking of monetary policy in terms of the cost of credit is strange.  I would consider the fact that 10 year treasury rates increased during the QEs to be a sign of the success of the QEs.  That success has nothing to do with cheap credit.  In fact, credit became more dear because expectations and investment demand improved.  If only the Fed had continued QE persistently instead of running it in starts and stops.

But, seeing the growing balance sheet as some sort of unified invitation to hyperinflation is incorrect.  First, the QEs were effective, but only weakly so, so it would take a lot of asset growth to trigger a little inflation.  Secondly, the initial growth in the Fed balance sheet was actually contractionary.

Friday, September 29, 2017

Housing: Part 259 - Phoenix home prices and interest rates

As readers who have watched my time-lapse chart of home price changes know, the price movements in bubble cities like Phoenix were peculiar, and they happened late in the process.  Late enough, in fact, that Phoenix prices still looked very normal, even as the Fed started to raise rates in 2004, and it was only after rates started to rise that home prices in Phoenix shot up.  That is because the bubble in Phoenix had little to do with monetary policy and much to do with a massive Closed Access refugee crisis that brought tens of thousands of migrants to Phoenix - some needing rental housing and some with sweet Closed Access capital gains cash burning a hole in their pockets.  These are the ingredients of a bubble.  And a classic bubble is basically what Phoenix had.  It just didn't have much to do with interest rates.

Of course there are many people who blame the housing bubble, in general, on loose monetary policy - the Fed held rates too low for too long and that caused buyers to borrow too much and to bid up the price of homes to unsustainable levels.  I have concluded that this is not correct.

But, all of that aside, and the "cause" of debating the truth of the matter, learning better policy prescriptions aside, given how widely that belief is held, these graphs are just funny.  If any Fred graph could make you laugh out loud, these have to be them.  The first graph is the price level in Phoenix compared to the Fed Funds rate.  The second graph is the one year change in the price level in Phoenix compared to the one year change in the Fed Funds rate.


Come, on.  That's funny.

So, I noticed over at Bob Murphy's blog in the comments of a post, there was some chatter among the Austrian Business Cycle folks about how low interest rates caused the housing bubble.  So I posted links to these graphs and asked for replies.  Nobody is going to change a deeply held belief over a couple of Fred graphs, so I thought it would be interesting to see what explanations they would come up with to explain how home prices accelerated as interest rates increased.  I was sure they would have some.

Bob even kindly copied the graphs into a new post for his readers.  There wasn't much reaction to it.  I really didn't even get to see many explanations.  I think I am accurately portraying the reaction by saying Bob and his readers didn't feel like this needed an explanation because these graphs are self-evident confirmations of the Austrian theory that low interest rates cause asset price bubbles.

Bob thought this third graph was the best way to look at it - with the Fed Funds level and the change in prices.  When prices were accelerating in 2005, rates were rising, but they were still relatively low compared to previous cycles, so they were still capable of fueling the bubble.

In the current version of the manuscript I am finishing, I sometimes try to get the reader to mentally commit to a stated expectation before I review the actual data. I wonder if I should even place empty graphs in the book and say, before you read the next chapter, draw a graph of what you think, say, homeownership rates did over this time period.  I think if I asked a room full of 100 Austrian BC proponents to draw a graph of home prices and interest rates, none of them would draw anything like this.  The blue hump would be one or two years earlier, at least.  None would have prices decelerating in 2002 and 2003.  But, upon seeing the actual graphs, fully 100 of them would agree that they had all miscalculated and placed the price run up too early.

In fact, the graph they would draw would probably look much like the graph of Los Angeles home prices.  That's because Los Angeles housing wasn't whip-sawed by a migration shock.  Los Angeles was the source of the shock, because the same rising rents that were the fundamental cause of the rising prices were also driving residents out of town.  And, yes, low (long term real) interest rates and flexible financing made those prices rise higher.

Whatever else you might say about it, though, the Los Angeles graph isn't very funny.

Tuesday, September 26, 2017

A List of Presentation Topics: Give your audience a new view.

The work I have been doing over the past two years has led me to many surprising conclusions about the economy and financial markets.  I have developed an incredible amount of material that will be thought provoking for many types of audiences.

I will be making a number of public appearances and presentations in 2018.  I expect to publish two books on the topics of the urban housing problem and the financial crisis early next year.  In the meantime, I can present this work to your firm, your trade group, your conference, etc.

If you have been following this blog, you know that the content here will contain new empirical evidence and concepts that your audience will either find surprising, dubious, or maybe even infuriating.  They will definitely leave with new food for thought.  I say that with confidence because I have had those reactions myself as I have discovered this story and its many facets.  Readers here also know what I'm talking about.  We have discovered these surprises together.

If you need a speaker please contact me via the email address in the right hand margin ( ).  If you know of someone who might be interested, please pass this post on to them.  This is a chance to give your group an early peek at the emerging understanding of the housing bubble and the financial crisis.

Because this project has developed such a broad reach, I can easily focus the topic on any number of specific ideas, depending on the interests of your audience.  Following is a list of some of those topics.

Various Audiences
A new retelling of the housing bubble and the financial crisis.  The motion graph here summarizes the story.
  • The bubble didn't make the US different.  The bust did.
  • The "Housing Bubble" Scariest Chart in the World should be disaggregated.  The housing bubble is a metro area phenomenon, not a national phenomenon.
  • The subprime bubble, and the CDO bubble were not associated with new homeownership.
  • Migration was a key factor in the housing bubble.  There are two distinct kinds of bubble cities.
  • The bust didn't undo a bubble.  There was a supply bust and we added a demand bust to it.
  • Mortgage defaults, and ultimately defaults of CDO securities, were largely the result of late decisions in credit regulation and monetary policy that undermined low tier housing markets in 2009 and after.

Financial Advisors & Real Estate Investors
There was never an overinvestment in housing or an inevitable supply overhang.  Understanding this provides insight into real estate investment potential.

Since 2007, there has been an extreme bifurcation of yields between real estate and fixed income asset classes.  This has implications for investors.

Since 2007, the US economy has experienced a regime shift in access to capital.  For those with access, this can lead to high returns.

Low tier real estate markets have experienced two distinct valuation shocks over the past twenty years.  Together, those shocks make low tier markets appear to be more volatile, but the shocks were unrelated to one another.  Going forward, these markets are likely to be less volatile.

Understanding the effect of housing on inflation can provide insights on Fed policy biases and the business cycle.

An upside-down CAPM.  Thinking of risk free interest rates as a discount subtracted from at-risk yields instead of thinking of at-risk yields as a premium added to risk free rates can yield subtle new understanding about the business cycle, investment returns, and leverage.

Public Policy
The high level of household debt is not funding consumption.  It is funding the obstruction of production.  Urban density is the gateway to equitable post-industrial abundance.

The mortgage crackdown has been a crackdown on young families and middle class homeowners.

A review of limited access governance and euvoluntary exchange.  If your "affordable housing" policy means that developers have to build "below market rate" units so that they can also build units whose prices are well above the cost of construction, then your city has actually implemented a peculiar and specific long term commitment to unaffordable housing.

The "China problem", secular stagnation, and labor immobility problems are actually housing shortage problems.  An unsustainable housing bubble didn't temporarily mask these problems.  Housing expansion was the sustainable solution to these problems.

Access is key.  The financial crisis was the result of a rejection of access, not a surplus of it.

The urban housing shortage leads to demands for ruinously tight monetary policy.  The housing shortage leads to zero-sum political battles.

Loose monetary policy didn't cause a housing bubble.  Monetary policy has ranged from neutral to tight for 30 years, and the housing shortage has a lot to do with that.

The GSE's mortgage guarantee, properly understood, is a monetary function.

Stability inevitably rewards the profligate and reckless.  Support stability anyway!  Raising risk spreads on purpose is the broken window fallacy applied to money.

Friday, September 22, 2017

The Housing Inventory Mystery

In real estate, and finance in general, I see a lot of standard analysis that seems backwards.  A lot of it would be something Scott Sumner would call "reasoning from a price change".  Analysis along the lines of predicting a decline in sales because prices have risen, making homes less affordable.  Prices are a signal of demand, not a cause of it.

This appears to be the case with inventory levels.  Inventory of homes for sale has been low during the recovery from the financial crisis.  Real estate analysts seem to commonly treat inventory as a signal of price shifts.  If inventory is low, that will lead to rising prices, because buyers have less supply to bid on.  If inventory is high, that will lead to declining prices.

This sort of analysis makes sense if we are looking at cyclical signals of a market with stable fundamentals that is constantly in a moderating process of finding an equilibrium of buyers and sellers.  In that context, rising inventory might signal an unexpected decline in demand, which would tend to lead to dropping prices.  That surely is what happened in 2006 and after.

We can see that the first measure to peak was homes sold but not yet started.  Homes sold but not started is almost a sort of negative inventory, and it had been high during the boom.  After that began to decline, builders soon responded by reducing the number of spec homes they were building.  Demand was falling fast enough that spec homes finished but not sold rose until the beginning of 2008.  Considering that new home sales continued to decline to very low levels until 2011, this seems like pretty responsive inventory control to me.  The inventory of spec homes declined pretty sharply in 2008, even as sales continued to crater.  Inventory of existing homes (not shown), on the other hand, did remain elevated until 2011.

Since then, inventory has moved back down to the low levels previously seen during the boom.  If inventory is a leading indicator of seller power, then this is a bit of a mystery.  Low inventory should trigger rising prices and new home building.  But, home price appreciation has been moderate, even with strong rent inflation, and new supply continues to only develop slowly.

The reason is that the housing market isn't in the midst of normal cyclical shifts.  It is in the midst of a wholesale secular shift in mortgage access.  A significant portion of the population that once could count on having ownership as an option, cannot anymore.  Some families have negative or minimal home equity, which makes selling or moving difficult.  Some families wouldn't be able to qualify for a mortgage for the homes they already own.  There has been a large shift from ownership to renting, because of this.  That shift, itself, probably tends to tamp down low-tier and mid-tier housing demand, because there isn't as much value in renting vs. owning, due to the lack of control over the asset, and it also means that a significant conduit of new supply - sales to new homeowners - has been cut off, forcing other buyers of new units (new supply) to make up the difference.

The reason inventory is low is because there aren't many potential buyers, and families that do need to engage in real estate transactions might have to downsize or shift to renting if they can't manage to get funding.

So, as with interest rates, the signal here is probably flipped from the way it is normally thought of.  If interest rates rise, that will be a sign of expanding investment, which would likely be related to an increase in households able or willing to take an equity position in new homes.  Rising interest rates will probably be related to rising home prices and rising housing starts, even though that might seem counterintuitive.  (Actually, regarding interest rates, I'm not sure that this is that unusual.  On a secular time scale, long term real interest rates reflect broad trends regarding saving/consuming, etc., and do seem to have an inverse effect on home values.  But cyclical shifts in interest rates, especially short term rates, are more a reflection of short term shifts in demand and sentiment, so that housing activity tends to be strong when rates are rising during an expansionary period.)

Likewise, rising inventory will probably only come about when there is a new shift to more potential homebuying from those marginal buyers.  Rising interest rates, rising inventoary, rising prices, and rising starts will probably all either develop in unison, or not at all.

Reflecting on monetary policy, if the Fed was actually following natural rates higher, we would be seeing these developments.  Instead, the yield curve is flattening, credit growth is moderating, housing starts remain low, and non-rent inflation is dropping.  I suspect that the natural rate will remain very low either until we allow mortgage markets to adjust to their previous standards, or until the housing market fully adjusts to the new standard, where middle class households are generally renters and are consuming housing, in terms of rent, based on those new stable standards, instead of being grandfathered into the homes they were able to buy before the shift.

I think the barriers to supply in the Closed Access cities, which is an international problem, also lower rates by reducing potential investment, but comparing long term real rates since the crisis to before the crisis, the mortgage collapse seems like it could be a larger factor.

There are obviously many international factors that play into interest rates.  But, these real estate distortions are huge.  The Closed Access problem probably inflates real estate values in the US by $3 trillion or more.  Internationally, this must amount to something like $10 trillion of capital value that required no investment.  Up to 2007, this meant that Closed Access real estate owners earned excess profits for preventing new homes from being built.  When they sold those properties and realized those unearned gains, the new buyers had to transfer cash to those owners, using labor income to fund transfers to capital.  This led to rising mortgages outstanding from the buyers, but it also led to rising savings on the part of the sellers as they re-invested their realized capital gains (although these gains are not generally included in official measures of savings).

Since 2007, federal regulators have prevented new homes from being built through mortgage constraints.  This has caused profits on existing homes to rise, but kept home prices low.  So, the effect on mortgages is the opposite - mortgages outstanding declined instead of increasing.  But, otherwise, this is similar - capital captures high rental income, but this income cannot be easily reinvested into real estate markets, so there is an obstacle to the investment outlet that would utilize savings in a way that lowered capital incomes and lowered yields in real estate.  Savings must be invested in bond markets or equities.  So, yields in real estate are above long term ranges and yields in bonds are below long term ranges.  This also probably amounts to more than $3 trillion in distortions.  Here, it isn't an inflation of savings; it is a decrease in potential investment.  $3 trillion worth of homes have not been built, in spite of being economically useful, since the crisis.

All told, there are more than $10 trillion of distortions in the global real estate market either inflating the value of prior savings or decreasing available investments.  And, we should keep in mind that, in terms of yield, these distortions are somewhat targeted.  Yields aren't low in real estate earnings.  Total expected returns to equities are not particularly different than they normally are (somewhere around 7%, in real terms, in the aggregate).  These distortions get focused onto fixed income markets that don't have obstructions.  Developed market debt markets amount to about $90 trillion.  Some of that is not investment grade.  It seems reasonable that these distortions could affect yields in low risk markets.

Given this, complaints about foreign real estate buyers seem misguided.  First, if you impose a strict set of policies limiting borrowing among domestic buyers, of course there will be an uptick in buying from foreigners with access to foreign capital outside those controls.  But, secondly, that capital inflow might actually lead to some new supply.  It can't lead to much supply in the Closed Access cities, which is where the complaints are usually lodged.  But, it might lead to supply elsewhere.

Wednesday, September 20, 2017

Fed Policy Updates

I happened upon this great line from George Selgin:

In recent Congressional testimony,I likened the Fed's gain in flexibility in a floor system* — its being able to set its policy rate however it likes, while altering the supply of bank reserves however it likes — to the gain an automobile owner might secure, in being able to turn the wheel as much as she likes, while also stepping on the gas pedal however much she likes, by shifting from Drive to Neutral. The problem, of course, is that, while the driver seems to have more options, the car no longer gets her where she wants to go.

This reminds me of two extraordinary paragraphs from Bernanke's "The Courage to Act" (pg. 325-326):
(I)n 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing—the federal funds rate.
Until this point we had been selling Treasury securities we owned to offset the effect of our lending on reserves (the process called sterilization). But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell. At that point, without legislative action, we would be forced to either limit the size of our interventions, which could lead to further loss of confidence in the financial system, or lose the ability to control the federal funds rate, the main instrument of monetary policy. The ability to pay interest on reserves (an authority that other major central banks already had), would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed. So, by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much lending we did.
Instead of lowering its target rate from 2% so it wouldn't run out of assets in the process of trying to suck cash out of the economy, the Fed found a new way to suck cash out of the economy to keep its target rate at 2%.  Three months of chaos ensued, and at the end of those three months, the target rate was lowered to near zero anyway.

During TARP, AIG, and all the rest of the chaos in September 2008, the Fed Funds Rate sat at 2%.  It has confounded me that every headline during that time didn't read, "Wait, why aren't they just lowering the rate?"  But, it's worse than that.  Part of the TARP legislation was the interest on reserves policy, implemented specifically to find a way to maintain a 2% policy without selling off every last liquid security the Fed had, which is what they would have had to do.

All of the drama of September 2008.  All the emergency programs, rule bending, arm twisting, etc. - it was all done so that the Fed didn't have to lower the Fed Funds Rate to a rate which it ended up targeting 3 months later anyway.  It's astounding that the Fed barely gets any criticism for that.  In fact, they would have received much more criticism if they had actually lowered rates and avoided all that drama.  As it was they were already being criticized sharply for trying to salvage the mess that arose.


In current news, this was today's press release from the FOMC:
Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.
They are "monitoring inflation developments closely". Now, there is no chance that they will lower rates because of low inflation over the next few months, so this statement is actually a statement of bias.  What this statement actually means is that they will raise rates at the slightest hint of an excuse.  They have an itchy trigger finger.

Likewise, the hurricane comments sound reasonable, but in practice what this means is that we are likely to get some positive noise in inflation.  I suspect that at some point, there will be a measured statement that basically says, "while the recent slight rise in inflation is partially due to recent hurricanes, we believe this is also a sign that inflation is beginning to rise back to our 2% target."  And rates will be hiked.

Today, the FOMC updated its forecasts, which included reducing their forward inflation forecasts.  Upon the news, the odds of a December rate hike shot up.  Now they are at about 70%.  Their 2017 core PCE inflation forecast is 1.5% - down from 1.7% in June.  (Keep in mind, even the FOMC expects some extra inflation from weather events, so this decline is after taking that into account.)  Core PCE inflation over the first 7 months of the year has amounted to about 1.3%, annualized.

I don't really blame the Fed.  They would face opposition if they did anything else.  From what I see in the financial sector, sentiment seems to strongly favor rate hikes.  If financial analysts come to that conclusion, there is no reason to expect other people to object.

Coincidentally, Hurricane Katrina hit in August 2005, in the middle of the Fed's rate hikes at that time.  Inflation spiked in September 2005.  By the end of the year, the yield curve had completely flattened.  Because of the asymmetrical potential value embedded in long term rates near the zero lower bound, the yield curve will probably still have a positive slope when we enter a contractionary context at this level.  I'm not sure we aren't close to that now, with 10 year treasuries at about 2-1/4%.

* Referring to the large balance sheet and paying interest on reserves

Monday, September 18, 2017

Hours Worked and Real GDP Growth

Over the long term, growth in real GDP correlates, naturally, with growth in hours worked.  Here, I have graphed the 10 year change in total nonfarm business sector hours worked (relative to population growth) and the 10 year change in real GDP.

There has recently been a decline in hours worked, which is partly demographic (aging baby boomers) and partly economic (the Great Recession).

There seems to be a long-term decline in RGDP growth of about 0.3% per decade.  Regressing real GDP against time and relative hours worked, we get the residual shown in the graph.  The regression suggests that for each additional percentage gain in hours worked, real GDP growth increases by about 0.68%.  I am using rolling 10-year growth rates.

By this estimate, growth in the 1990s was largely related to rising work hours.  Then, in the 2000s, work hour growth declined, but GDP growth continued to be normal.  Then, with the Great Recession, hours worked and GDP growth fell.  Now, growth in hours worked is low.  But, real GDP growth is low, even adjusted for slow work growth.  I suppose that could still be demographic, since older workers are exiting the labor force, and younger workers are entering.  It probably isn't a coincidence that the GDP growth residual declined as baby boomers were entering the labor force, rose for 30 years as they aged, and then started to decline as they began to leave the labor force, although clearly the sharp trend shift is related to the Great Recession.

tl;dr: There was a sharp drop in total hours worked beginning in about 2000.  This would be enough to drop real GDP growth rates significantly, and it probably did.  But, real GDP growth has been even lower than this sharp drop in hours worked would suggest.

PS: Broken record alert: For the past decade, residential investment as a percentage of GDP has been about 1% below long term averages and construction employment as a percentage of total employment has been about 1% below long term averages.  Add 10% to the 10 year measure for both hours worked and real GDP and your within range of normal.  It's about housing..... One might argue that there is competition for scarce resources and you can't just add real GDP growth without accounting for pulling those resources away from other uses.  But, I believe there has been a decade long search for the answer to the mystery of idle labor, long-duration unemployment, and a glut of savings that happens to coincide with this shift.  If ever there was little tradeoff for marginal investment, it has been now.

Friday, September 15, 2017

August 2017 CPI

This month, trailing 12 month inflation remained at about 1.7%.  Core inflation less shelter remained low: 0.1% for the month and 0.5% for the year.  Rent inflation this month spiked, which is mainly what is keeping core inflation above 1%.

On the news, it looks like the odds of a Fed rate hike in December jumped by about 15%, (currently 55%).  I appreciate that the Fed is trying to base their policy on real time data.  The problem is that they seem to have bought into the fear that they are the cause of high equity and home values.  And, they treat high rent inflation as a monetary issue, when it is a supply issue.  So, I think they are sincerely trying to follow the data.  But, the problem is that these conceptual errors bias them toward wanting to raise rates.  So, it doesn't really matter if they are trying to follow the data.  If the data follow some stochastic process, and each time there is data noise, the Fed adjusts their expectations with even a slight bias, the trend of those expectations will still be mainly an effect of that bias.  So, at some point, they will be convinced that we need another rate hike because that is their bias.  Probably just as well that it's December as opposed to next year.  We might as well get it over with if it is inevitable.

Thursday, September 14, 2017

Housing: Part 258 - YOU rigged the economy.

Maybe this is repetitious, but I'm not sure if I have written about this is exactly this way before.

Consider two of the most widely and strongly held opinions about the financial crisis:
  1. The system is rigged.  We bailed out the banks who did this to us, and we left Main Street and regular families high and dry.
  2. We have prudently put new safeguards in place in order to prevent the reckless lending and speculating that caused the bubble.  One fortunate result of the federal takeover of the GSEs, the passage of Dodd-Frank, and the collapse of the subprime market, is that lenders are now much more selective about who they sell mortgages to.
Think about that for a minute.  What were the bailouts, really?  There were a few examples of the government basically taking over the equity position in some firms, generally at a profit.  There was general monetary accommodation.  And, there were various emergency loans.  Generally, in panicked markets, the Fed was engaging in one of its core roles - acting as lender of last resort.

Basically, the government loaned money to various firms and financial institutions, to make a liquid market, expecting to earn a return on those loans.  And, in the end, it generally has.

So, if the government had treated both "Wall Street" and "Main Street" the same, then, what would it have done?  It would have funded mortgages in illiquid markets as a sort of lender of last resort, expecting to earn a return.  So, then, why didn't it do that?  The answer: See point two above!

The reason the government didn't "bail out" "Main Street" is because we wouldn't stand for it!  Consider the oddity.  It's like we insist on not having our cake and being upset about it too.

At exactly the same time that the federal government was funneling trillions of dollars to "Wall Street", it was knocking the wind out of middle class housing markets at Fannie and Freddie.  After the takeover, the GSEs completely eliminated any growth in mortgages outstanding for FICO scores under 740.  This, coming on the heals of the complete collapse of the subprime and Alt-A securitization markets that had been serving some of that market.

In a panicked market, the federal government turned out the lights, and we cheered for it between our complaints of rigged markets.

Given this situation, what could the federal government have possibly done to mimic on "Main Street" what they had done for "Wall Street"?  We wouldn't dare let them be an actual lender of last resort.  That left a bunch of unlikely and costly second best options that were never going to amount to much.  And, so we complained that they weren't trying hard enough.

The lack of any reason for this becomes more clear as we realize the full picture of the markets of the time.  The new paper from  Stefania Albanesi, Giacomo De Giorgi, and Jaromir Nosal is just one in a line of papers that show the owner-occupier market was not in need of retraction.

This is clear even in basic national survey data, like the American Housing Survey and the Survey of Consumer Finances.  Homeownership had peaked in 2004.  The number of first time homebuyers had been declining pretty steeply since 2005.  There had never been any expansion of homeownership among households with lower incomes who would have difficulty making payments.

And, because the federal denial of a lender of last resort was so targeted at these credit constrained households and neighborhoods, it was the period after this when home values really collapsed in those markets.

There was a housing contraction in 2007 and 2008, and a financial crisis in late 2008.  Then, because of belief number 2 above, there was a third crisis in 2009 and 2010 that was actually more severe than the main housing contraction we all recognize.  That crisis only hit working class neighborhoods.  We rigged the system, and we're still patting ourselves on the back for it and demanding that someone, somewhere, correct this vexxing injustice.

We were nearly unanimous in our opposition to a Main Street bailout.