Precommitment

Given some of what I have seen on the net I need to do a serious (much more than this) post on asset prices and defaults. I think some people are conflating the decline in asset values from the bursting of the credit bubble with the value of defaults.

Indeed the former is significantly larger than the first. For example, if I told you that a bond you thought was perfectly safe when you bought it for $100,000 actually had a 25% chance of being worthless what would you be willing to sell it for? I guessing much less that $75,000.

Now suppose that a financial enterprise you were invested in had been raking in big profits by buying these $100,000 bonds that now have a 25% chance of default, how much less do you think your investment would be worth. Remember that this not only includes the fact that the bonds are worth less but the realization that the supposed big profits in the past actually came from buying stuff that is a money loser today. What does that tell you about the potential for future profits and how would that effect your valuation of your investment?

Alarmism and Rational Panic

Two commenters have pointed out that my last post seems excessively alarmist.

I think I may have obscured my own point. I am not attempting to get people to sell in a falling market, so much as admitting that the only honest advice I could give is to sell in a falling market. Given that I think people will eventually find their way to optimality, this indicates to me that the market response will be different than in times past.

There is good chance that the point will come where Floridians realize that to some extent this is a game of who can get out first. I think first mover advantages can cause rational bubbles, that is, bubbles in which each individual agent has a private incentive to buy into the bubble. In the same way a first mover advantage has the potential to create rational panic.

Given that rational panic is probably extremely rate in housing, I don't think the past will be a good guide for the future.

Home Price Decline Will Be Different This Time

Lots of people have been comparing the national experience today with Los Angeles in the 1980s. Overall prices are inflated roughly the same amount and so the same decline is expected. There are a few reasons why I expect the price collapse to be more rapid and further.

1) The supply of homes increased rapidly during the boom yet the supply of potential homeowners is now falling. I believe that the core driver of the worst parts of the housing boom was a dramatic increase in the number of potential homeowners, created by declines in lending standards. As lending standards rise the number of homeowners will fall off rapidly.

2) The best advice that I could give to someone who is underwater right now and in non-recourse state is to walk away from your home. Take the hit now and start rebuilding your credit.

3) The best advice that I could give to someone who still has equity in a bubble area is to sell. Sell now. Things will only get worse in real terms. You are losing equity when you could be earning interest. Worse yet if illness, job loss or family emergency force you to sell in a hurry then you could loose dramatically more.

In short if you live in a bubble region the only reason to stay in your home right now is because you love your home. A lot. Otherwise it makes sense to get out before everyone else does.

Walk Away Nation

Suppose, housing price to income ratio fall back to their historic norms. What are the worst consquences of massive declines in home equity.

My fear is that looking at years of being underwater and the likely prospect of having to move for family or job reasons some time in the next 7 years, that potentially hundreds of thousands if not more than a million Alt-A and perhaps even Prime borrowers will walk away from their homes.

We may reach point where walking away is the financially prudent thing for these people to do, not to mention the least painful in the short term. They become subprime borrowers for seven years but they we likely to be forced into selling the house for less than they owed within seven years anyway. Yet, in this case they get to move from what is bone crushing monthly mortgage payment to a much more reasonable monthly rent payment.

There may be some sense of embarrassment for many middle class borrowers to walk away from their homes and become renters but its the type of phenomenon that could become rapidly more popular once the first, most desperate home owners do it with few consquences.

In this case we are looking at a rapidly accelerating rate of foreclosures and perhaps a housing bust that begins to feed on itself and even overshoots the long run equilibrium by a substantial amount. How possible is this scenario? I don't know but it worries me.

Fed Statements Coming Back To Haunt Them?

Repeatedly your blogger suggested that the Fed's credibility might take a blow during this financial crisis, without more aggressive efforts to manage market expectations.

I suggested that they hold in Oct, but signal high levels of responsiveness. That would have paved the way for a "shock and awe" 50 bps cut in December with a similar signal that the Fed is prepared to move rapidly. If they held in Oct, it is unlikely that the market would have been expecting 75 bps.

When they disappointed the markets in Decemeber they should have made mention to the strong GDP numbers in Q3. Let the market know that they see the future but we are in fact coming out of a rapid expansion and the Fed has to be sensitive to that.

Instead we have had a series of confusing statements and moves.

I do not envy the FOMC, Bernanke in particular. They are facing what may be the toughest challenge since the Great Depression. However, I do think that now is not the time to experiment with transparency.

Now is the time to offer statements that will serve to boost market confindence.

Now is the time to say that we are prepared to act rapidly when bad data comes in. Remind the market that the Fed takes employment and output to be the variables of interest, not asset values. However, as threats to employment and output materialize there will be a strong and vigilant response.

We can probably expect data that supports, what everyone believes to be true by mid January, thus implying that the Fed will move strongly in Jan and March to relieve stress to the real economy.

By the bye Nouril Robini is starting to convince me. More one that later.

Was There A Housing Bubble . .

or a simply a credit bubble.

This may seem like a widly pedantic inquiry. What difference, if one even exists between the two, does it make whether there was a housing bubble or just a "credit" bubble? Prices are falling and that is obvious to anyone.

I do think it makes a bit of difference, though, in thinking about how this whole thing is likely to unfold and how to prevent it again.

Some people lay the blame for this crisis at the feet of Alan Greenspan and his failure to diffuse what was obviously a growing problem. The question for me is - from a macro perspective how obvious was it?

My own take is that the current crisis has most of its seed in the structured debt boom. Housing prices started to rise early in the decade from easy money and a decline in world wide long term interest rates. To the extent that this was the whole story we wouldn't have that serious of a problem on our hands.

Tightening monetary policy would have slowed down the rise in housing prices and we probably would have been able to pull of a soft landing. The problem is that at exactly the time monetary policy was tightening, credit standards were loosening, big time.


There was a sense, ill-placed as it may have been, that risk could be managed with far greater efficiency than ever before. And managing risk is terribly important. Had structured debt lived up to its hype it would have meant a revolutionary change for millions of Americans. It would have meant the opening of opportunities, the forgiveness of pass indiscretion and new chances which would lead to an eventual unleashing of entrepreneurial ingenuity. That, however, was not to pass.

So it turns out that people have fewer opportunities and banks are less willing to overlook imprudence. Thus, the dream home and dream opportunities that would have been yours, cannot be. This is real and it is a loss.

That's important, because it means that the bursting of this bubble is not as William Buiter suggests, a zero-sum game. We are not simply transfering income from current homeowners back to future homeowners. We slashing the opportunity sets of millions of current and future homeowners a like. Such an adjustment will be inevitably painful in the short term and I am not sure there is effective means for preventing something of the sort from happening again.

Inequality and Growth

Quick post to get feedback on an idea.

I am beginning to think that inequality, in and of itself maybe an important component in at least the level of economic activity if not the rate of growth.

Why?

Well, traditional economic theory is based on the idea that people either work or not. If they work they get the prevailing wage. Higher wage can potentially encourage people to work more but even this is controversial since higher wage people don't "need" to work as much.

The thing is work is not work is not work. That is, the same person doing two different jobs could enjoy radical differences in productivity and hence income.

For example, it is not uncommon for an investment banker to be paid on the order of $500 an hour. Unless we think that the investment bank is in the business of giving away profits we have to concede that she is then producing at least $500 in value for the firm.

Suppose that same women were to become a cashier at the local dollar store. Now, no doubt she will be a great cashier. She will probably be faster and make fewer errors than the typical cashier but how productive could she be really? Could she produce ten dollars an hour, maybe at the outside fifteen dollars an hour worth of economic product.

Lets say she produces ten dollars an hour. Then the choice of this young woman to become a cashier rather than an investment banker will cost the economy $490 per hour of output. That's the same as if 49 cashiers had become unemployed.

Therefore, it much more important that we get this young woman to work in the correct field than it is that we get her to work at all.

Getting her to work in the right field doesn't depend so much on what the average wage is, or what the average tax rate is for that matter. It depends on the inequality in after tax wages between fields.

One thing that is striking about Europe is the intellectualism of the working class. Waiters on Champs-Elysees are able to and interested in discussing all manner of geopolitical issues. Socialist tend to applaud this as a mark of France's egalitarian nature. Even the wait staff are literate members of the body politic.

Yet, I am struck by the economic waste. If this person is both capable of and interested in geopolitics then they should be assisting the world in geopolitical decisions, not serving baguettes.

If it turns out that we can both educate and interest everyone in geopolitics, finance and the like, then no one should be employed as a waiter. After all, its not that difficult to grab your own baguette.

The Height Tax Properly Understood

Greg's height tax is receiving some renewed attention. When originally proposed I objected to the tax on the grounds that if a part of the redistribution schedule were based solely on height it could have the unintended consquences of transferring money from a poor tall person to a wealthy shorter person.

Greg responded by email that there is no reason to tax the poor tall or give payments to the wealthy short. The tax could be non-linear.

Now, such a tax is still somewhat disturbing to my sentiment Yet, I've come to believe that this is based on the inability of my moral compass to digest non-linearity. That is, when thinking about the tax it is difficult for me to intuit the effects of a redistribution principle that depends simultaneously on two values potentially moving in opposite directions.

So how about this. Suppose using God's Current Population Survey (by that I mean one that is all knowing and completely infallible) we are able to determine the individuals who achieved success because they were tall and those that were denied it because they were short. We can also effortlessly transfer a portion of income from the lucky tall to the unlucky short. Would it increase or decrease equality to do so?

In other words, let's forget about the fact that Greg's paper depends on correlations, non-linear tax systems and economic approximations. Let's pretend that we know for a fact that some people have gained benefits solely because of their height and others have incurred costs. Would it then still be unjust to redistribute.

My gut says no, and this makes me believe that sentimental problem with the tax is not due to the outcome but the opacity of the method. The tax doesn't strike as moral because it's so darn morally confusing.

However, as economists we shouldn't let that stop us. The minimum wage doesn't strike most people as being unjust to the poor but careful analysis reveals that it often is. Likewise, the height tax doesn't strike us as a just way redistribute, but if we are willing to imagine a simpler redistribution system which accomplishes the same goal we see that such a system can improve justice.

Fed Cuts - Very Dovish Statement

The real statement below, with commentary in bold italics

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/4 percent. Widely expected

Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Starting with the outlook for growth. Not even recognizing the strong numbers from Q3. This is very dovish in my estimation. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time. Almost as if they are saying we actively working to stop what is an imminent recession.

Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.I wouldn't read too much into this. Failure to mention commodity prices in this market would be dereliction.

Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. I expected this at the top of the statement.The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. No explicit bias, but one has to assume that we are in a cutting cycle based on the language at the top.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; and Kevin M. Warsh. Voting against was Eric S. Rosengren, who preferred to lower the target for the federal funds rate by 50 basis points at this meeting. Wow! This is what caught my attention. No votes, not even Hoenig, to hold and a single preference for 50 bps.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 4-3/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, and St. Louis.

I am surprised by the softening of business and consumer spending language. I am surprised at no mention of Q3 numbers. I am surprised that no one voted to hold.

My best guess is this is a way of saying. We see a recession coming. We are working to stop it, but there remains a chance we could be wrong.

One Amazing Meme

Via Mark Thoma

It is truly amazing that right now everyone in the country is deferring to Paulson and the heads of Countrywide, JPMorgan, Bank of America and others as the best group to work out a solution to this problem. No one is talking about the fact that these people created the problem and profited to the tune of hundreds of billions of dollars from it.


One of the most resilient memes in the western (if not human) conscious is that of the ever profiting powers that be. Its one thing to argue that Countrywide, Citigroup and others created the subprime mess, its another to think that they are profiting from it.

Since, when is facing a 10 Billion dollar write down and widespread rumors of bankruptcy profiting to the tune of hundreds of billions of dollars.

25 bps

I would cut 25 bps and and here is a quick not well edited sample statement:


The Federal Open Market Committee decided to lower its interest rate target to 4-1/4 percent.

Recent data suggest that economic growth has been solid and that employment growth remains strong. However, since the committee's last scheduled meeting conditions in financial markets have deteriorated, approaching levels present this summer. In addition, the ongoing correction in the housing market and the associated disruptions in the market for subprime mortgage backed securities threatens the outlook for growth.

Core inflation has continued to moderate as expected though commodity prices have remained elevated and the committee judges that some risks to inflation remain.

While risks to both inflation and output remain the committees predominate concern is that further weakness in financial markets will lower the outlook for growth. While today's action reduces the risk for further financial deterioration the committee will continue to evaluate data as it becomes available.

In a related action the Board of Governors unanimously approved a 25 basis point decrease in the discount rate.

The language here is meant to give room for another move in the discount rate in late December or early January should things fall off a cliff. The worry is that the Fed needs some tool to calm the market if and when things start going bad without spooking them because of unexpected Fed action.

With this we can set up a one-two punch, 25 bps here and a possible cut at the discount window around the new year. The hope is that will get things functioning back to normal. Its going to take some time for exports to come to the rescue but if we can keep the bottom from falling out until next summer I think we have reasonable shot at making this a mild recession.

The worry of course is with some securities going from AAA to worthless (yes, I don't mean junk or even default I mean nothing, nada, not a dime, no recovery whatsoever) in less than a year its hard to see how there aren't some significant freeze up in credit markets.

Where I Spit Out My Evening Tea

I am sure most of you have seen this but are you kidding me!

I've never said all tax cuts pay for themselves. I never even said Reagan's tax cuts would pay for themselves."
Arthur Laffer

HT Mankiw

Here We Go Again

Looks like UBS may deliever some more write downs on subprime. Will more banks and brokers fess up on fourth quarter before Christmas? If so the probability of a Santa Claus rally is slim.

Hat Tip to Caluculated Risk (the best real estate blog by far)

By the bye I am looking for 25bps from the Fed this week, but who isn't. I'll try to get in my mock statement before tomorrow is up. End of the calendar year is a busy time in the ivory tower.

Oct All Over Again

Mike asks if the ADP report reduces the probability of a cut.

Well, the word about the blogosphere is that ADP has some issues with its November forecast. I have not looked into to it, but it seems Nov is always an outlier. The question is what number we get on Friday.

Another issue is the market response. I had been thinking of a post on the "Long Bear Case"; the possibility that we could see an inflation adjusted decline in US equity values well into the next decade. The sell off in the market prompted me not to hold off, so as not to be overly alarmist.

However, I think it is equally important to think about whats happening now. The current run up feels like Oct all over again. Then talk was ripe that we had priced in this whole subprime mess and could get on with the business of going upward.

I think this is unlikely. My guess is that things are likely to get worse. Significantly worse. There will be more write downs in the forth quarter and consumer spending will start to sting in early to mid 2008.

The decline in housing prices will steadily weaken the consumer because most of the pain comes through credit constraints. That is households stop spending because the bank stops lending money, not because they simply "feel" poorer.

Indeed, the "smart" household is loading up their HELOC now. Money is only likely to become harder to come buy and who really thinks the prime rate is headed up from here? If you want to buy it, you'd better buy it now. That's what the mortgage brokers are going to be selling and they are correct.

To me this means that consumer weakness is going to become much more pronounced next year than it is this year.