Follow-up to previous post (read that first.)

When the tech bubble burst the Wicksellian equilibrium real rate fell to very low levels.  In that situation, the Fed must cut interest rates sharply to prevent a sharp fall in NGDP and a depression.  They did so.  Whether they then raised them fast enough in the middle of the decade is a harder issue, and there are good arguments on both sides.  But I’d like to focus on arguments for a housing boom in 2002.

In a classical world (on the PPF) less business investment should lead to more residential investment.  Some commenters object when I call housing construction “investment.”  Just like real men eat steak and not sushi, real investment is supposed to be factories and infrastructure, not houses.  They see houses as a sort of consumption.  America consumes too much, and houses are exhibit A.  I think this is totally wrong; there is almost no entity that is more “capital-like” than houses.

A can of beer is a capital good that depreciates rapidly as you drink it.  Hence we call it a “consumption good.”  The longer-lived an asset, the more capital-like it is.  In a recent comment section Mark Sadowski made this point:

Isn’t the real consumption of useful capital taking place right now? Menzie Chinn recently alluded to the fact that growth in potential RGDP has probably slowed in the face of a persistent and massive output gap. And I keep reading local news stories about well maintained manufacturing facilities that were highly profitable until just three years ago being torn down because no one expects sufficient demand to come back anytime soon.

This reminded me of just how short the useful life of many so-called “capital goods” really is.  Think computers.  Or factories.  Or even stadiums and basketball arenas.  They actually tear down perfectly good arenas that I recall being touted as new and modernistic in the 1970s.  (Meanwhile the Roman Coliseum is still standing.)  In contrast, my house is 90 years old and perfectly fine.  Around me are many houses 100, 150 even 250 years old.  All still in good shape.  All still producing housing service “output.”

Suppose you were a central planner, deciding what America should do in 2002 to keep people busy (idle hands are the devil’s workshop.)  Business investment is out because of the tech crash.  Two percent of Americans can feed us all.  It used to take 30 percent to make manufactured goods, but even without imports we’d need a far lower number today due to technology.  Soon only about 5% of Americans will be able to produce all the manufactured stuff we need.  Most Americans already have the refrigerators and washers and cars they want.  If I were a central planner, I suggest two uses of labor; more houses and more fun.  People love nice houses with granite countertops (when I remodeled in 1997 I put in formica, and I bitterly regret it every day of my life.)  We all see pictures of dream houses we’d love.  And if we have the things we need, then more services.  Restaurants, hotels and hospitality.  Service jobs.  More houses and more services would seem to have been the best way to keep people busy and boost living standards after business investment crashed in 2002.

It boggles my mind that so many people wring their hands that we might have built a couple of million too many houses over a few years, in a country with 120 million units.  In the grand scheme of this does it really matter all that much if a house built in Phoenix is only occupied for 145 years of its 150 year life, instead of 150 years of its 150 year life?

Some would say “what about the banking crisis, the recession?”  What about them?  Yes, those are the big problems we should worry about.  But they have little to do with building a few too many houses.  Those failed mortgages were mostly re-fis, as people used their houses as ATMs.  Or mortgages on the purchase of existing homes.  The losses to the financial system from people not paying back their mortgage on a newly-built house are way too small to explain the great financial crisis of 2008.  And I already showed the housing slump doesn’t explain the recession, as it occurred way too soon.

It seems like the misallocation of capital into housing construction was a disaster.  Actually it was a minor problem that was correlated with two major disasters, horrible mis-regulation of our financial system that allowed risky loans with tax-insured dollars, and really bad monetary policy that allowed NGDP expectations to fall sharply in 2008.

Those are some really nice new houses out there.  Now let’s print some money so that people can enjoy them.  (But only enough money to get proper NGDP growth, not enough to bail out all the bad investments.)

Brad DeLong might be right.  At the recent AEA meetings he said something to the effect that America has a housing shortage, as many families are doubling up. I thought it was a clever, counter-intuitive way of thinking about the aggregate demand shortfall.

This got me wondering about the commentators who insist that easy money caused America to build a vastly excessive number of housing units, and that’s why there are record housing vacancies today.  It seems to me that when you look at the data, housing construction has not been excessive in the period beginning in 2002, when the Fed allegedly cut rates too low.  See what you think, and as you do so keep in mind that America had 220 million people in 1978, and 300 million by 2008.  So construction in per capita terms has actually had a slight downward trend since 1978 (the earliest figures I could find.)

Source: U.S. Census Bureau

Here’s my assumption.  Housing construction normally seems to fluctuate between one and two million units. Let’s take 1.5 million as roughly the trend rate which keeps up with population.  Yes, it’s true that we exceeded that number every single year from 2002 to 2006, and the total excess production was about 1.87 million units.  That’s a lot.  But over the next four years there was a shortfall of about 2.6 million units.  So why do we seem to have a hugely excessive number of homes, if we are actually 730,000 short?

One answer is a decline in immigration.  A year ago I suggested that the decline in immigration might have played a role in the housing crash.  I think it’s fair to say my theory wasn’t met with widespread acclaim.  So if that’s why I’m wrong today, if less immigration explains our housing surplus, I’ll take it.  At least I would have been right last year, on a point all the pundits missed.

But I doubt that’s big enough to make a major difference.  Even last year I merely suggested it was a contributing factor in the Southwest.  A more likely explanation is that the sharp fall in NGDP led to mass unemployment, especially among the young.  This caused them to start living with their parents, even when in their 20s (something I couldn’t even imagine doing when I was young.)  In that case the problem isn’t that too many houses were built (well actually a few too many were, but they should have been quickly absorbed in a country with 120 million units) but rather too little demand, because people have too little money.  And who determines how much money there is in the economy?

There’s a way to test my theory.  If the other side is right, and we have all these vacant homes because we built way too many in the middle of the decade, then the number of vacant home should have dropped rapidly during the last three years, and especially during the last two years.  The year 2008 was the first year below a million since my records began in 1978 (and probably much earlier.)  That’s clearly below any reasonable estimate of normal absorption.  Then in 2009 and 2010 we were down close to a half million units, a mind-boggling low rate of construction.  Vacancies should be plunging under any reasonable estimate of market absorption.  But guess what, over the past three years there has been no decline in housing vacancies (assuming I am reading the 5 year version of this graph correctly); vacancies have leveled off since March 2008 at just under 19 million units, up from 16 million in early 2006.

Given ultra-low construction, and US population growth of about 3 million/year, there is only one explanation for that pattern.  Astoundingly low demand for housing.  Do young people actually enjoy living with their parents, or might America be experiencing an aggregate demand shortfall?

Another reason we need more NGDP.

This was spurred by a Chicago alumni magazine article that made the following claim:

Economic recovery will be slow, [Erik] Hurst says, because the massive misallocation of resources that the housing boom created cannot be quickly remedied. During the ten years after 1997, he said, 40 percent more housing was constructed in the United States than in any decade on record. Today 2.3 percent of single-family homes are vacant, an increase of more than 64 percent since 2005.

The housing oversupply, in turn, has contributed significantly to high unemployment. As the construction industry boomed, much of the American workforce shifted to housing-related industries, on both the construction and banking sides. Now, of 3 million open jobs in the United States, only 65,000 are in housing-related fields, Hurst said. Thus, many unemployed workers are qualified for jobs that are no longer available””jobs, he predicts, that won’t come back.

This is completely inaccurate.  As you can see from the table, housing construction in 1998-2007 was only 8.4% above the levels of 1978-87.  And it was much lower in per capita terms.  The 2.3 million single family homes that are vacant are probably little changed from a few years ago, whereas the number should be plunging with low construction.  There is no reason construction jobs shouldn’t come back, unless we shoot ourselves in the foot.  As I showed, housing construction in the past decade has been below normal.  If all you knew was the housing construction data from the noughties, you’d expect another 1.5 million homes a year to be built in the teens, just like other decades.  I’m not saying that will happen.  Indeed I think it won’t happen.  But if it doesn’t there will only be two possible explanations; a crackdown on immigration or a prolonged NGDP deficiency (perhaps combined with supply-side problems with the labor market.)  It won’t be because we built too many houses in the 2000s.  We didn’t.

PS.  Please do not tell me about local housing markets.  I am claiming America has too few homes; I completely agree that Detroit and Vegas have too many.

There’s no question that Arnold Kling’s recalculation view is more intellectually appealing than the messy arguments about wage stickiness used by us “GDP factory” proponents:

Regular readers know that I am trying to nudge them toward a different paradigm in macroeconomics. I want to get away from thinking of economic activity as spending, and instead move toward thinking of it as patterns of sustainable specialization and trade. Even if there is only a small chance that this alternative paradigm is useful, I think it is a worthwhile exercise.

One reason for wanting to change the paradigm is that I believe that trying to describe economic activity using an aggregate production function is a mistake. When I use the derisive expression GDP factory, I am referring to the aggregate production function.

Yes, macroeconomics should be all about specialization and trade.  Except business cycle theory, which needs a special ad hoc sticky wage/price model.  Why?  Because the evidence simply doesn’t fit any other approach.  Here’s Kling on the construction bust:

I want to suggest that the output that is “lost” is output that people do not want. In 2008 and 2009, Americans do not want 2 million houses to be built. So I do not think that it is right to speak of a shortfall in output. Instead, we should say that the people who were building houses have not found a pattern of trade in which they can produce something that people want.

Yes, housing output was low in 2009 and unemployment was high.  But is there a causal relationship?  I say no.  Housing starts peaked in January 2006, and then fell steadily for years:

January 2006 — housing starts = 2.303 million, unemployment = 4.7%

April 2008 — housing starts = 1.008 million, unemployment = 4.9%

October 2009 — housing starts = 527,000, unemployment = 10.1%

So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes.  Looks like those construction workers found other jobs, which is what is supposed to happen if the Fed keeps NGDP growing at a slow but steady rate.  Then NGDP plummeted, and housing fell another 480,000.  Is this because people didn’t “want” those houses?  No.  They didn’t want 2.2 million new houses a year; that really was a societal screw-up (with many possible villains.)  Kling’s completely right about that.  But they probably do want about a million new houses a year as our population grows by 3 million per year and families average about 3.  The reason housing fell far below normal is because the severe fall in NGDP created a deep recession.  Unemployed factory and service workers aren’t going to buy new houses.

Most importantly, the huge run-up in unemployment did not occur when the big fall in housing construction occurred, but much later, when output in manufacturing and services also plummeted.

Here is Kling on the Great Depression:

I think that technological change can drive the marginal product of many workers close to zero (When I mention ZMP, I always feel I owe Tyler Cowen a footnote.) I suspect that this happened in agriculture in the U.S. in the late 1920’s and early 1930’s, dumping a lot of manual laborers into unemployment.

I don’t agree with this.  There had been a very long term secular decline in farm jobs going back for decades before the Depression.  Those workers gradually moved to the cities and were absorbed by growing manufacturing and service industries.  So what changed between the booming late 1920s when unemployment was about 3%, and the early 1930s when it rose to 25%?  The answer is manufacturing collapsed, as industrial production fell by roughly 50%.  It was factory workers losing jobs that explains the Great Contraction, not farm workers.  Yes, farm workers continued losing jobs, but there was no longer any place in the cities for them to find jobs.  Why not?  Because NGDP fell in half between mid 1929 and early 1933.

Here’s Kling on oil prices:

Could “pumping up demand” help in such a situation? Perhaps. But if the recalculation story is right, the higher demand could end up not doing much for employment. Instead, it might only do a lot to raise oil prices.

Of course more demand could raise nominal oil prices by boosting inflation.  But with CPI inflation running around 1% it’s more likely that Kling is referring to an increase in real, or relative, oil prices.  Could monetary stimulus boost real oil prices?  Absolutely.  But if and only if it raised expected levels of output and employment.  In other words, if and only if it was expected to work.

In my next post I’ll address Tyler Cowen’s ZMP workers argument.

Many economists (even some relatively free market economists) have begun to question the high returns flowing to the financial industry in recent years.  It’s not that people don’t understand that finance is important, or that it plays a critical role in our economy, but rather the claim is that finance is much more generously rewarded than in the past, and that those extra earnings are at least partly unmerited.

Today I’d like to defend finance.  Not the role it played in the housing debacle (in that specific case I agree with the critics.)  Instead I’ll try to show that even in the absence of policies such as Too Big To Fail, you would expect the share of income going to finance to be rising sharply, as compared to earlier decades.

Let’s start with a simple economy that produces lots of wheat and a little bit of iron.  The income distribution in society mostly reflects differences in productivity in farming.  Stronger farmers can produce somewhat more than weaker farmers, but not a lot more.  Hence income is distributed fairly equally.

Suppose productivity in the mining industry mostly depends on skill at noticing iron deposits.  Let’s also assume that this skill is distributed very unequally–some people are much better at spotting iron deposits than others.  The next assumption is crucial.  Once iron is found, it can be mined very easily.  The hard part is finding the iron in the first place.  In that sort of economy, income will become less and less equally distributed as iron becomes a larger and larger share of GDP.

In the 1950s and 1960s it wasn’t that hard to figure out where capital needed to be allocated.  Capital was allocated to produce steel, and the steel was used to produce cars and washing machines.  Capital was allocated to the production of aluminum, and the aluminum was used to make airplanes. The most productive members of society were those who made things, and Michigan was near the top in per capita income.

Today the most productive members of society are not those who produce things, they are those who discover the things that need to be produced.  Once you have the blueprint, it is easy to produce many types of software and pharmaceuticals.  The big money goes to those who figure out the blueprint, but also to those who allocate capital to the guy who has the idea for a Google, or Facebook, or Twitter.  In contrast, the technicians who actually implement the vision often earn modest salaries.  Thus companies are “discovered” in much the same way as an iron deposit is discovered by a skilled geologist.

And then there’s globalization, which means decisions about allocating capital can vastly improve productivity even in the old-line industries that were dominant in the 1960s, when the rest of the world hardly mattered.  Finance is not that important in an agricultural economy or even in an economy where the mass production of goods can be done with almost military precision.  It becomes extremely important in an economy where it is not at all clear what should be produced, or on what continent that production should take place.

I’m not sure if I’m saying anything new—this analysis is sort of related to the “economics of superstars.” But if it is well-understood, why do people seem so perplexed by the fact that finance earns much bigger incomes than in the 1960s?  Finance now plays a much more important role than in the 1960s.

Perhaps people are drawing the wrong conclusions from the housing fiasco.  Finance made a serious mistake in allocating so much capital to housing, but that’s not what caused the recession.  In a country with 100 million houses, the damage from adding two million a year for a couple years instead of one million a year for a couple years is modest.  The reason we have a severe recession is because of tight money, not too many houses.  Otherwise we would have had a severe recession in 2006-08, when housing construction collapsed, rather than 2008-09, when we actually had a big downturn.  And of course much of the sub-prime mortgage fiasco had nothing to do with housing construction, it was refinancing.

As long as we have an economy that is increasingly dominated by “idea companies,” where the idea is really, really hard to discover and really easy to implement once discovered, finance will earn huge gains.  In my model economy the iron spotters were highly productive and the iron miners had a relatively low marginal productivity.

Right now, those who develop new ideas are being highly rewarded.  More importantly, those who spot good ideas developed by others, and allocate capital to implement those ideas, are also highly rewarded.  Get used to finance earning obscene profits, it isn’t going away.  But if it makes you feel any better, they are producing something of great value (except when they screw up and allocate money to sub-prime mortgage borrowers.)

Some might point to the fact that finance also earned high incomes in the years right before the Great Depression.  And yet we obviously did not yet have high tech economy.   But those high incomes merely reflected the extraordinary bull market.  Today finance earns large incomes even during years where stock prices are not soaring.  In others posts I’ve argued that income is a pretty meaningless metric, as it is distorted by the mixing wage income and capital gains.  Whenever stock prices soar income will temporarily look much less equal.  But our recent move toward greater inequality is not just driven by stock gains during bull markets; it’s a secular trend that isn’t going away anytime soon.

This is a follow up to my previous post.

Part 1:  Capitalism later

When I was young I believed the GOP was more supportive of small government than the Dems.  I’m not sure why I believed this; when I came of age Nixon was president, and he was arguably the most anti-libertarian president of my lifetime (with the important exception of ending the draft.)

Supporters of the GOP always used to say that the president (Nixon, Ford, Reagan) wanted smaller government, but the Congress wouldn’t go along.  When the GOP finally took Congress in 1994, the alleged roadblock was President Clinton.  Finally, in 2001 nirvana arrived for us libertarians; the GOP took all branches of government, and we got . . . one of the biggest new entitlement programs in history, a massive increase in the National Security State, and a much greater Federal involvement in education.  The fastest growth in Federal spending since LBJ was president (for several years.)

That should have ended any illusions about the GOP being the party of small government, except to the most hopelessly deluded.  But with the rise of the Tea Party movement we are again hearing this meme—the GOP wants to trim the size of government.  For instance, the GOP has spent the last two years bashing Obama for not reining in Fannie and Freddie.  And now that they have taken Congress, the Wall Street Journal says they are ready to act:

Earlier this year, leading House Republicans proposed to privatize mortgage giants Fannie Mae and Freddie Mac or place them in receivership starting in two years.

Now, as Republicans prepare to assume control of the House next week, they aren’t in as big a rush, cautioning that withdrawing government support in the housing market should be gradual. . . .

Republicans were backing a bill by Rep. Jeb Hensarling (R., Texas) to start cutting the government’s ties to the mortgage giants or begin winding them down in two years; if they were deemed financially viable, they would become fully private within five years.

“Of all the dumb regulation that caused our economic crisis, none was dumber than that which created the (Fannie and Freddie) monopolies,” Mr. Hensarling said in March. . . .

Many Republicans now concede that a speedy exit may not be practical, because Fannie Mae and Freddie Mac have such a dominant position in the nation’s housing market. Mr. Garrett said he has “not established a specific timeframe for winding them down.”

[Insert obligatory Claude Rains exclamation here.]

Some might argue that the GOP is simply facing reality, the economy is weak and a drop in the housing market might further depress aggregate demand.  But since when is the GOP worried about AD?  They have been insisting that the Fed is making a mistake in trying to boost AD with a more expansionary policy—that this would merely bail out the Obama administration’s failed big government policies.  No, the GOP is not motivated by a desire to boost AD.  And neither are they opposed to more intervention in the free market.

The mostly like explanation is that the GOP’s paymasters in real estate and banking quietly had a word with them after the election.  I’d guess it went something like this:

“We greatly appreciate the help from the Tea Party in getting you guys back into a position of power.  But now these neophytes need to step aside and let the big boys take over.”

So which is it?  Is the GOP lying when they say we don’t need more AD, and that Fed policy is too easy?

Or are they lying when they say we need smaller government, and that the housing fiasco was caused by people like Barney Frank, who promoted the GSEs?

Part 2:  Regulation later

And then there’s the Dems.  They used the subprime fiasco to rail against unregulated free market capitalism, the so-called “market fundamentalism” of people like . . . well people like me.  Of course the true market fundamentalists were always opposed to the housing/banking system, which was riddled with moral hazard.  Unfortunately there were plenty of so-called market fundamentalists who cheer-leaded the “deregulation” of banking the the US, Ireland, Iceland, etc, thereby discrediting the entire movement.

In any case, the Dems did get around to “re-regulating” the housing mortgage system in the US.  More than a kilo-page of re-regulation.  There’s just one thing, they forgot to ban un-insured subprime mortgages.  That’s right, the alleged cause of the entire mess, which is already banned in many countries the Dems seem to hold up as models, was given a free pass.  There is no requirement that buyers put at least 20% down.  Indeed there is no requirement that they put even 5% down.  Nor are there any plans to phase in such a ban over a 5 or 10 year time frame.

So if regulation isn’t really the motivation of the Dems, what is?  The same WSJ article provides one answer:

Democrats tend to favor a more active role for the government in housing to ensure that underserved communities have access to mortgages.

So there you are.  The GOP doesn’t favor small government and the Dems don’t favor regulation.  Instead the GOP favors a bloc of people who vote for the GOP and contribute money to their campaigns, and the Dems favor a bloc of people who vote for the Dems and contribute money to their campaigns.

I’m not so cynical (yet) that I would deny there are some idealists in politics.  My hunch is that some politicians (even some I don’t like such as Barney Frank) are driven partly by idealistic motives.  After all, Frank recently mentioned abolishing Fannie and Freddie.  But whatever idealism exists is not strong enough to overcome the special interest groups.

Fortunately, good governance is not a zero-sum game, so once and a while the two parties come together and strike a deal that is win-win (such as the 1978 deregulation bill, or the 1986 tax reform, or the 1996 welfare reform.)

The most one can hope for is that some creative politician will be able to cobble together another such compromise sometime in the next 10 years.   Of course it would be much easier to do if we were Switzerland, Denmark, or Singapore.  Heck, if we were even Canada or Australia.  But we are a nation of 310 million people with very diverse cultural values and perspectives on economics.

Happy New Year!