Misguided Policies

From the wires:

15:30 *PAULSON SAYS MARKET TURMOIL WON'T ABATE UNTIL HOUSING REBOUNDS

Such comments always leave me with a sick feeling in my stomach – if policymakers are waiting for the housing market to rebound, they had better be prepared for a long wait. Sort of like waiting for the NASDAQ to revisit the 5,000 mark.

I think the biggest potential for policy error lies in maintaining the delusion that preventing housing, and by extension, consumer spending, from adjusting is central to fixing the nation’s economy. Policy would be best focused on supporting the inevitable transition away from debt-supported consumer dependent growth dynamic.

Housing prices are falling because fundamentally the price of housing became unaffordable. The stream of expected household income necessary to repay the loans exceeded the capacity of household budgets. It is that simple – there is no sense in paying $3,000 a month in mortgage payments on property with the rental equivalent of $1,000. To be sure, a homeowner could justify such a purchase as long as they thought they were guaranteed a 15% annual risk free return. But who, other than realtors and mortgage brokers, remains under that delusion?

Similarly, I find programs that purport to “help” homeowners by reducing their mortgage payments of questionable value. Lowering your mortgage payment to 38% of income might sound like a good deal – but if you have no equity, you do not really own anything. You are just a renter by another name. So if your final mortgage payment significantly exceeds the rental equivalent, has the government really made you better off? And if, as I suspect, homeowner bailouts will not stem price declines, the program recipient could soon find themselves with negative equity again in a matter of months. If you really wanted to help underwater homeowners, you would bring their payments in line with the rental equivalent. I suspect this would be extremely costly.

That housing prices will ultimately return to some conventional relationship with incomes does NOT imply that the government has no role in supporting the housing market. The government’s role is simple: to take actions that ensure that persons who can afford a mortgage remain able to do so.

The Federal Reserve and Treasury need programs that allow credit worthy borrowers access to credit. This justifies the takeover of the GSEs, and even justifies pouring billions of dollars into them to ensure that the family earning $60k a year is able to get the mortgage for a $200k home.

The problem for housing prices, of course, is that two years ago that same family could purchase a $400k home. Unless policy is expanded to encourage such loans, then the supply of funds is no longer available to support $400k homes. If policy is redirected toward such a goal, then the government, and ultimately the taxpayer, will take on additional credit risk in one form or another. There will be pressure to use the GSEs in this fashion. Consider this proposal, via the WSJ:

As part of an industry proposal called "Fix Housing First," builders are asking Congress for a tax credit of up to $22,000 on houses bought over the next year and an interest rate buy-down that would reduce rates on new, 30-year fixed mortgages to 2.99% for houses bought through June 30, 2009. The proposal could cost up to $268 billion, according to the National Association of Home Builders, though the group may scale it back.

Thirty year money costs the US Treasury 4.2%, so obviously the taxpayer is expected to make up the difference. I suspect this proposal would cost vastly more than $268 billion, as it would ultimately be expanded to refinancing as well. Why shouldn’t those of us who want to stay in our homes be on the same terms?

Moreover, can anyone imagine that the government could end such a program? Might as well hope for the mortgage interest tax deduction to be eliminated. I can see that a guarantee of ultra-low interest rates would support the housing market, but I don’t see how the resulting massive unfunded liability could be supported with anything less than outright monetization of deficit spending.

In a similar vein, we are seeing increasing interest in supporting consumer access to credit. Treasury Secretary Henry Paulson today announced that TARP is no longer about troubled assets:

Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit.

Again, policy should rightfully focus on maintaining credit to the credit worthy. But we should draw the line at encouraging lenders to make risky loans. The Federal Reserve has the right idea:

At this critical time, it is imperative that all banking organizations and their regulators work together to ensure that the needs of credit worthy borrowers are met. As discussed below, to support this objective, consistent with safety and soundness principles and existing supervisory standards, each individual banking organization needs to ensure the adequacy of its capital base, engage in appropriate loss mitigation strategies and foreclosure prevention, and reassess the incentive implications of its compensation policies.

Unfortunately, I suspect such jawboning will have little impact. With consumers already overextended, the room for rapid credit growth is simply limited. Moreover, with economic activity deteriorating and unemployment rising, the number of credit worthy borrowers is falling. This comes on top of the deleveraging already underway in the financial sector. The Fed and Treasury are able to do little but prevent the banking system from outright collapse.

Simply put, policies focused on housing and consumer spending are a black hole for spending – this summer’s short-lived stimulus package is a case in point. Policymakers need to come clean with the American public: Future patterns of growth will simply be less dependent on consumer spending.

We are entering a period of structural adjustment, and it will be painful. We spent decades pretending that the relentless focus on producing nontradable goods and relying on a ballooning current account deficit to hide our lack of productive capacity was an appropriate policy approach. But ultimately, those policies have failed us, with stagnant income growth for median income families and the deepest recession since the 1980’s (or even worse).

This admission, however, in no way, shape, or form means policy options are limited. The admission simply defines your policy.

In the short term, policy can cushion the transition by expanding the social safety net. In the medium term, if consumption is falling, and private investment is unable to compensate, then the federal authority should fill the gap.

There is no shortage of sectors of the economy that offer opportunities for investment. In so many ways, we are running on the fumes of the infrastructure investment made by the last generation. Roads, bridges, channels, etc. – you name it, there is an opportunity. Or human capital, via education?

Should the federal government finally step up and fund unfunded mandates? And by all means, continue efforts to reform health care, including the development of nationwide, portable medical records tracking. Reasonable policymakers free from ideological constraints can develop a host of potential projects without relying on bridges to nowhere. You can even extend the argument to supporting Detroit – if current management and boards are swept clean.

Can we afford these policies? For the moment, yes. I did not believe this in the first half of the year, as I thought the global economy was running too hot to support substantial stimulus without an inflationary offset. That is no longer the case.

If we reach a point we can’t finance the spending, financial markets will tell us. All policymakers have to do is listen and adapt. And I think it is much more likely that we can afford investment spending that yields productive assets rather than taking on the risk of refinancing the housing market at less than the cost of funds. Indeed, I think relentless focus on housing prices will lead to rash policies that could only be inflationary in the long run. After all, the key to supporting housing prices is simply to inflate nominal incomes.

In short, policymakers need to envision an economy in the future that is distinctly different from the past. Relying on the housing market to propel growth is a failed policy. Relentless upward leveraging to support consumer spending was not sustainable. Accept the failure, and move on.

Comments

[Drew Horn:]

"The economy of the future" is destined to be socialism! The form os it is likely to be more extreme compared with England, France, Germany, etc. The only hope to avoid it is if a great leader who truly believes in capitalism emerges but the only person I can think of who has both common sense and credibility is Warren Buffet but he is a bit long in the tooth for the task.

It seems that selfish hedonism isn't limited to consumers and their credit cards. It started with the financial services industry who seem to be without effective leaders is wholly lost except to follow their normal instinct to exploit all that can be exploited. Their fictional hero, Gordon Geko's motto " GREED IS GOOD" is their only focus. They have forgotten that the reason for business to exist is to provide goods and services. The rest is simply frills.

2008 Nov 13 10:27 AM

[Tom Lindmark:]

Thank you. That was a fine article. No pie in the sky plans just a rational analysis of the inevitable direction the economy is going to go.

2008 Nov 13 11:00 AM

[Jane:]

It's not just mortgage brokers and real estate agents who are delusional, you can add homebuilders too. Their plea for a bailout and govt tinkering w/house prices is evidence of that. I am thoroughly disgusted with America's corporations. They spend zillions every year lobbying for less accountability for themselves and claim it's about capitalism and in some way good for the consumer. But when their greedy, stupid, even criminal business practices drive the economy off a cliff, they suddenly turn socialist, but only for their own benefit as usual. These companies deserve to fail, and frankly many of their upper management & CEOs should be doing prison time. They've been immune from indictments by paying fines to govt agencies or getting no punishment at all. The same actions by lesser companies have resulted in bankruptcies and even arrests. There is no good reason the big companies' people should be treated differently than the rest of society.

2008 Nov 13 12:08 PM

[axelrod608:]

Excellent article, and one that points out yet another fallacy on which our "bailouts" are based. Every day we seem to discover more examples that illustrate that the assumptions on which government policy is based just aren't true.

Clearly, if you take away the liar's loans and teaser rate loans, home prices will have to drop substantially to be affordable. Add a requirement for some downpayment, and the pool of buyers shrinks. Combine that with record high credit card and other consumer debt, and your buyer pool contracts even more. Add to that the growing ranks of the unemployed, and it becomes clear that home values are swirling in the bowl.

While it may be true that the economy won't turn around until home prices stabilize, the idea that it will happen in the next quarter - or even the next year - is clearly naive. The fat lady isn't even fat yet...

2008 Nov 13 01:22 PM

[mallarde:]

I have been thinking the same thing. An economy built upon a Ponzi scheme cannot be saved by trying to re-build the scheme after it has been uncovered and disrupted.

And trying to turn housing prices around... does anyone know anything about economics? Actually, I know firsthand the answer is "no."

2008 Nov 13 02:41 PM

[Kunst:]

The US will devalue the dollar by creating new money to buy the debt it can't sell without much higher interest rates, which would just worsen the situation in several ways. A larger money supply will create asset and wage inflation that will make houses affordable to those who already own them. House prices will go up, eliminating the negative equity problem while reducing the percent of (increased by inflation) income necessary to service existing mortgages. Lenders and renters are screwed, but hey, you can't please everybody. Watch out for those oil prices, though.

Of course (to quote Richard Nixon), "that would be wrong". I'm sure our government wouldn't do anything like that. Better to have millions more foreclosures, unemployed people, and bankruptcies. Even though we haven't had a truly balanced budget in the last six decades, I'm sure we will soon start expeditiously paying off our national debt.

2008 Nov 13 11:54 PM

[Tony Petroski:]

You are right, the cost of housing became unaffordable. You are wrong in thinking that affordable housing is far along the horizon.

2008 Nov 14 01:25 AM

[john1:]

Just more unpatriotic negativism from liberals who question the party, and REAL Americans.

2008 Nov 14 01:10 PM