1.  China’s trade deficit.

Lots of people have linked to the most recent trade data from China, which show a deficit in March.  One month may not be that important, as China is expected to swing back into surplus.  But buried in the report is this almost mind-boggling statistic:

China’s exports totaled $112.11 billion in March, up 24.3 percent from a year earlier. Imports reached $119.35 billion, up 66 percent compared to the same period last year, the Customs Administration said in data posted on its Web site.
Den ganzen Beitrag lesen…

Barney Frank starts off by trying to blame the Bush administrations for the financial crisis:

And the Clinton Administration was better than the Bush Administration.  When the Bush Administration came in, they appointed people who didn’t believe in regulation. So it was not that the banks captured them, it’s that they volunteered to become parts of that operation.

I agree, but it is not at all black and white, as this New York Times story from 2003 shows:

WASHINGTON, Sept. 10″” The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago.

Under the plan, disclosed at a Congressional hearing today, a new agency would be created within the Treasury Department to assume supervision of Fannie Mae and Freddie Mac, the government-sponsored companies that are the two largest players in the mortgage lending industry.

The new agency would have the authority, which now rests with Congress, to set one of the two capital-reserve requirements for the companies. It would exercise authority over any new lines of business. And it would determine whether the two are adequately managing the risks of their ballooning portfolios.

The plan is an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac — which together have issued more than $1.5 trillion in outstanding debt — is broken. A report by outside investigators in July concluded that Freddie Mac manipulated its accounting to mislead investors, and critics have said Fannie Mae does not adequately hedge against rising interest rates.

”There is a general recognition that the supervisory system for housing-related government-sponsored enterprises neither has the tools, nor the stature, to deal effectively with the current size, complexity and importance of these enterprises,” Treasury Secretary John W. Snow told the House Financial Services Committee in an appearance with Housing Secretary Mel Martinez, who also backed the plan.

.   .   .

Significant details must still be worked out before Congress can approve a bill. Among the groups denouncing the proposal today were the National Association of Home Builders and Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing.

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

Barney Frank defended his actions by arguing that he favored low income rental support, but opposed sub-prime lending.  Even so, I can’t help thinking that tighter oversight of the capital reserve ratios would have been helpful.  Frank also argues that the Obama administration is doing a much better job regulating:

One of the things that happened under the Bush Administration was the FHA, was allowed to deteriorate.  We’re building that back up again with safeguards.

Maybe so, but given that these new “safeguards” allow people with credit scores of 590 to get FHA mortgages with 3.5% down-payments, I am not reassured.  I am also not convinced by the following, although Cochrane and Taylor will agree:

Bernanke and Paulson, came to us in September of 2008 and said, “If you don’t act, there’ll be a total meltdown.  There’ll be the worst depression ever.”  By the way, even if you didn’t think that was going to be the case, and I think it probably was, when the Secretary of the Treasury and the Federal Reserve say, “If you don’t do this, there’ll be a meltdown,” there’s going to be a meltdown.  It’s a little bit self-fulfilling.

If there is one thing we have learned from this crisis, it is that we need to separate politics and banking.  There was far too much political pressure (from both Democrats and Republicans) for banks to make loans to people who simply could not afford to pay them back.  That wasn’t the only problem, but it was certainly part of the problem.  Thus I was not reassured by this statement from Congressman Frank:

They tell us, “Oh, but if you make us pay this tax, we won’t have any money to lend.”  First of all, they’re doing a lousy job of lending now and we’ll be having a hearing a couple weeks after this interview to force them to do more if we can.

Have we learned nothing from the crisis?

There are good things in the interview, such as a promise by Frank to end the too big to fail policy.  But how can that sort of promise have credibility as long as Congress keeps following the Augustinian maxim:

O Lord, help me to be pure, but not yet.

There is only one comment that really annoyed me:

Unfortunately, the economy was deteriorating, I think as a consequence of their refusal to regulate the financial industry, and President Obama inherited one of the worst recessions in history, the worst since the Great Depression, and it is much harder to do things in a very depressed economy with revenues tied up and people hurting than it was in a good economy.  So by the policies that led to this terrible recession that Obama inherited, things became more difficult.

Obama did not inherit the worst recession since the 1930s.  Here are some unemployment rates:  Nov. 1949 – 7.9%, May 1975 – 9.0%, July 1980 – 7.8%, Dec. 1982 – 10.8%, Jan. 2009 – 7.7%.

Yes, Obama inherited a bad economy.  It’s a shame he didn’t ask Cristina Romer how FDR was able to turn things around immediately.  How FDR took office in March 1933, a period of rapidly rising unemployment, and within a little over a month had industrial production rising at the fastest rate in history, despite a banking crisis far worse than the one Obama inherited.

By the way, in December 1983 the unemployment rate was 8.3%.  Yes, that means that a mere 12 months after unemployment peaked at 10.8% in December 1982, it had already fallen by 2.5%.  This time around unemployment peaked at 10.1% in October 2009.  I hope it falls by 2.5% by October 2010, but most forecasts I’ve seen suggest it will still be around 10% at that time.

Obama should consider himself lucky that the economy was mismanaged so badly under Bush.  This gives him some breathing room, as many people have bought into the false assumption that there is nothing that can be done about the recession in the short run.

By the way, NGDP rose 6.36% in the 4th quarter.  This is the best we have seen in quite a while.  Nevertheless, I keep emphasizing that the focus needs to be on the expected growth rate of NGDP.  We don’t have a futures market, but my reading of various indicators is that NGDP is likely to grow at about 5% going forward, perhaps even less.  And that is not enough to recover quickly, although unemployment may fall gradually as wages adjust.

I would also note that nominal final sales only grew by about 3%, and this is the indicator that Bill Woolsey looks at.  I think this also explains why most forecasters expect NGDP growth to slow—as the fourth quarter saw a sharp slowdown in the rate of inventory liquidation.  But the final sales aren’t there yet to support robust NGDP growth going forward.

I hope this doesn’t sound too negative.  The 6.36% figure is much better than what we have recently seen.  Further good news comes from the 5.7% rise in RGDP, confirming my supposition that the SRAS is very flat right now, and that any boost to NGDP will mostly show up in the form of higher real output, not higher inflation, until unemployment falls somewhat.  Just to be clear, I oppose real targets like unemployment; consider this a prediction of the likely real implications of the nominal target I do favor.

A recent FT article by Vernon Smith and Steven Gjerstad discusses two big housing crashes, one occurred between 1928 and 1929, and the other occurred between 2006:1 and 2008:2.  Both were associated with substantial increases in RGDP.  Why didn’t real GDP decline during these two big shocks to a major industry?  Why was unemployment so low?

There are two reasons.  First, jobs in housing construction are not a particularly large share of total employment.  The direct loss of jobs was in the 100,000s, not millions.  In addition, many of the workers who lost jobs in construction gained jobs in other sectors.  Thus RGDP continued to grow.

The article by Smith and Gjerstad contains two of the best graphs I have ever seen for illustrating the amazing resilience of the US economy.  In 1929 (a boom year) housing output fell by roughly 30%.  The recent downturn is even more striking.  Notice the severe decline in housing for 9 straight quarters during a period where RGDP is trending upward. The ability of RGDP to grow while a major sector is contracting is quite amazing.  Yet for some odd reason they drew almost the exact opposite conclusion that I did; they argued that the housing crashes of 1928-29 and 2006-08 caused severe recessions.  Why is that?

In my view their key mistake was to misinterpret the role of monetary policy.  In each case, housing continued to decline further after the period I cited.  And in each case NGDP, which had been growing, suddenly began declining as well.  It was the decline in NGDP, not the additional fall in housing, which caused the severe recession and the job losses all across the economy.  If NGDP had kept growing at 3% to 5% after 1929, and after 2008:2, the housing downturn probably would have ended, and the economy would have avoided a severe recession.

You might ask; “Isn’t it a bit implausible that two severe recessions would be preceded by housing collapses, if those collapses had no causal role in the recessions?”  In fact, the housing collapses and the subsequent recessions probably were related, but in a very indirect fashion.  Here’s what probably happened in both cases.  As housing declined, the equilibrium “natural rate of interest” began to decline as well.  There was less demand for credit.  At some point the natural rate fell far below the Fed’s policy rate, causing monetary policy to tighten accidentally.  Because Fed officials (and many private economists) wrongly think that the level of interest rates are a good indicator of the stance of monetary policy, they failed to notice that monetary policy had tightened sharply.  But the markets noticed, and there were big stock market crashes in October 1929 and October 2008.

But that can’t be the whole problem, because Smith and Gjerstad do discuss the fall in velocity, and correctly attribute it to the decline in nominal interest rates.  And of course this fall in velocity is just another way of thinking about the fall in the natural rate of interest that I discussed earlier.  So they understand that a housing collapse can reduce interest rates, velocity, and hence NGDP.  So again, why do they reach such different conclusions?

I think in the end it has to do with their approach to monetary policy.  They view the fall in velocity as something that the Fed would have had a hard time counteracting.  And they would undoubtedly point to the fact that the Fed did in fact fail to counteract it.  In contrast, I am much more optimistic about the ability of the central bank to maintain stable expected NGDP growth in a period of financial turmoil, and believe that very little of the fall in velocity that Smith and Gjerstad cite was actually caused by the housing slump.  Instead, almost all of it was caused by two monetary policy mistakes.  One was the failure to do NGDP targeting, level targeting, which would have maintained positive longer term NGDP expectations.  And the other error was paying interest on excess bank reserves.

In his Big Think interview, Vernon Smith suggested that banks took excessive risks in the 1920s.  This seems plausible, after all, lots of banks failed in the 1930s.  But in fact banks were much more conservatively managed in the 1920s than today.  If you take a close look at this graph from The Economist, you will see that bank equity was above 10% of assets throughout the 1920s, and was close to 15% on the eve of the Great Depression.  So that wasn’t the problem.

Then what went wrong?  Why did so many banks fail in the 1930s?  The answer is simple, NGDP fell in half.  The funds people and firms use to repay loans comes from income.  If nominal income falls in half, there will be many defaults, regardless of how sound the loans seemed before the Depression began.

What about today?  It is more complicated.  This time Smith is partly right.  There were many foolish loans made during the past decade, and we know this because the sub-prime crisis occurred while the economy was still booming in 2007.  About all you can say in defense of the banks is that the fall in NGDP after mid-2008 made the losses several times worse than otherwise.  But even some of that is the banks fault, as they need to anticipate the possibility of at least a mild recession, although perhaps one can excuse them for not expecting NGDP to fall at the fastest rate since 1938.

In any case, it’s not about blame, it is about figuring out where we go from here.  And despite the fact that I diagnose the problem slightly differently from Smith and Gjerstad, I reach almost identical policy conclusions from those discussed by Smith in his recent Big Think interview:

1.  We should require much more collateral on loans and derivatives

2.  We should raise the price level 6% (although I would substitute NGDP for the price level.)

PS.   I couldn’t copy the FT graphs, but this one from The Economist shows just how much of the housing downturn had occurred before the recession even began.  Starts had fallen from over two million to roughly one million in late 2007.  In the early part of the recession, starts actually leveled off at close to one million, but then fell to 500,000 when NGDP declined sharply.

PPS.  Tyler Cowen links to a graph showing the effect of “recalculation.”  Oddly, a few weeks back I linked to a similar graph arguing that it showed recalculation was a minor factor in the current recession.  BTW, the graph he links to has an error; unemployment rose between July 2009 and November 2009, whereas it shows a decline.  But I shouldn’t throw stones as a commenter named Tom found errors in my graph as well.

I was born in Michigan, grew up in Madison, and went to grad school in Chicago.  These three areas encapsulate how I think about the recession.  Chicago is a cross-section of America, with a highly diversified economy.  Its unemployment rate is 10.3%, close to the national average.  Madison is blessed with unusually acyclical industries, and I don’t recall it ever experiencing high unemployment.  Because its economy is dominated by state government, college education, insurance, biotech, and dairy, it has only 5.5% unemployment.  At the other extreme is Detroit, with 15.4% unemployment.  Detroit has two problems.  First, heavy industry is unusually cyclical, and thus steel, autos, machinery, etc, will suffer more job losses when AD falls, even if there is no recalculation.  Of course the auto industry is the main problem in Detroit.  It is not true that the US auto industry is in a long term state of decline, but the Big 3/UAW auto industry is in a long term state of decline.  So Detroit’s unusually high unemployment rate is due to both cyclical factors and structural (recalculation) factors.

HT:  Mike Belongia

Back in May 2003 The Economist said that many countries were in the midst of a housing bubble:

A SURVEY in The Economist in May predicted that house prices would fall by 10% in America over the next four years, and by 20-30% in Australia, Britain, Ireland, the Netherlands and Spain. Prices have since continued to rise, so have we changed our mind?…

I’ve already discussed the US; in this post I’d like to examine some foreign markets.  Nick Rowe has an excellent post on bubbles, and he argues that Canada did not experience a housing bubble.  Before considering Nick’s assertion, take a look at this graph of average Canadian housing prices (you must click on the graph link on the right.)

Nick argued that if there had been a bubble then you’d expect that once prices stopped rising and began falling, then people would worry that the bubble had burst and prices would fall sharply.  Prices did fall a bit when the worldwide recession hit Canada in late 2008, but then began recovering in the second half of 2009.  So he concluded there was no bubble.  My hunch is that he is right, although as they like to say on Wall Street “past performance is no guarantee of future success.”

[Note; while working on the post I noticed that Nick’s co-blogger Stephen Gordon has a very informative post on the Canadian housing market.]

My theory all along has been that the US housing bubble was widely misunderstood, and that if NGDP had kept growing at a 5% rate after mid-2008 then the US housing bust would have been far milder.  More specifically, in heartland markets like Texas there would have been no housing bust at all.  Most of the damage would have occurred in 4 key sub-prime states, and even in those states the price declines would have been far smaller.

One implication of my hypothesis is that in most other countries the housing crash should have occurred later than in the US, and should have been far milder.  The Economist, which ironically is the publication that I most strongly disagree with on this issue, has published a graph that strongly supports my hypothesis.  If you click on the link you will see an interactive graph that shows global housing trends since 1990.  I found it easier to read by moving the starting point to 2000:1, and go up to 2009:3, the last observation.  And I used real housing prices, which should make it easier to spot bubbles in countries that have inflation.

Many countries experienced no unusual increases (Germany, Switzerland, Japan, Hong Kong, China, Netherlands, etc.)  Other countries like France experienced a sharp increase, but only a very small decline.  Australia and (to a lesser extent) Canada also fit this pattern.  Furthermore the timing of the decline is clearly associated with the 2008-09 recession, which reduced NGDP in the US, Europe and Japan.  Also note that where housing downturns eventually did occur, they were generally more severe in countries that had severe recessions (UK and Ireland) and relatively mild in countries where the recession was much milder (Australia and Canada.)  So it looks like we can say there was (at best) a housing bubble in the US, and to a lesser extent a few other countries like Spain and Ireland.  But no global housing bubble.

I believe that portions of the US market, and perhaps to a lesser extent the Irish and Spanish market, became overvalued in early 2006.  The other English-speaking countries also saw large increases in real housing prices, just as in the US.  But because they experienced much milder declines, and because those declines were closely associated with the severe global recession, I don’t see how you can call them bubbles.  A severe recession is a fundamental factor that would be expected to reduce housing prices even if the EMH explained 100% of house price changes.

While my falling NGDP story explains most foreign downturns, The Economist’s bubble story seems inconsistent with these inconvenient facts:

1.  Prices in most other “bubble” markets did not decline when the US market turned down in 2006.

2.  The declines in other markets were generally much milder, even when the preceding price increases had been just as rapid as in the US.

3.  Housing prices turned up recently in places like Australia and Canada, despite their being “overvalued” according to The Economist.

So you shouldn’t believe people who tell you that we are in a bubble, and who defend that hypothesis by merely pointing to fast rising prices.  Ex post, people like Krugman and Shiller were right, but only about the US.  In many other countries large price increases did not lead to a major collapse, and prices are still quite high in early 2010.

Of course if you wait long enough prices will eventually fall in any country, that’s how markets work.  But it turns out that it is much harder than most people imagine to predict which prices are “obviously overvalued,” and hence bound to fall sharply.  We all know about confirmation bias.  Because most elite economists live in the US, and pay little attention to countries like Australia, they tend to assume that recent events have provided decisive support to their bubble hypotheses.  Yet from a global perspective bubble theories haven’t done well at all.  Indeed they performed quite poorly over the past 10 years.  Outside of the US and Ireland, you would have been better off if you had ignored The Economist’s bubble warning of 2003, and instead had gone out and bought a house.  But what about those who base their forecasts on fundamentals, and not merely the rate of price appreciation?

If you look at the specific countries cited in The Economist’s famous prediction, the results are far worse than even for the US.  Recall that in May 2003 The Economist predicted 20% to 30% prices declines in 5 foreign countries.  If you set the starting point at 2003:2 and use nominal prices, then you will see that prices rose by more than 10% in the Netherlands, and by anywhere from 30% to 55% in other 4 countries.  Not exactly the 20% to 30% price drops they expected.  Some of my commenters claimed that The Economist was right in the long run, because prices did eventually fall.  I don’t think that argument is right—surely you must be held to the terms of your prediction, otherwise there is no way to ascertain how good you are at forecasting.  But even with those very generous assumptions, they were still far off base.  Even today the Netherlands continues to show a greater than 10% gain.  Spanish, British and Australian housing prices are still up by 30% to 50% over 2003 levels.  Only Ireland is even remotely close, with its price appreciation having fallen to about 10%.  But even that prediction is far from the 20% to 30% price drop forecast by The Economist.  The most generous assumption of all would be to use real housing prices.  But even in that case none of the 5 showed price declines over the following 4 years, and only Ireland experienced a tiny decline between 2003 and late 2009.

So The Economist’s predictions of 10% to 30% price declines over 4 years were spectacularly off base.  Even over a 6 1/2 year time frame, only the US (the country they thought was the least overvalued) experienced a significant decline in house prices.  And then only in real terms.  So in all 6 countries their predictions were wildly inaccurate for the 4 year time window they specified.  And even under the most generous assumptions, using real housing prices and a 6 1/2 year time frame, The Economist’s predictions were still highly inaccurate in 5 of 6 countries.  What an awful record of forecasting housing prices through the use of “fundamentals.”  This shows just how difficult it is to identify bubbles in real time.

I am not a believer in bubbles.  That doesn’t mean I don’t think bubbles exist, rather I don’t know of any coherent definition that is useful.  At the same time I gladly admit that (ex post) the bubble theories do seem to match the price movements in housing circa 2004-06, or tech stocks around 1999-2000.  Krugman argued here that bubble theory also explains commercial real estate (CRE) price movements over the past decade.  I do not agree.

First a bit of perspective.  CRE has always been much more volatile than residential housing.  I recall many examples of sharp declines in the prices of big city office buildings.  I would lump commercial real estate in with commodities and equities as three assets that are very pro-cyclical.  This is especially true if the cycle is caused by a demand shock, a sudden and unexpected fall in NGDP.  Indeed I view these asset price movements as a much more important part of the monetary transmission mechanism than the fed funds rate.

When you first glance at the graph in Krugman’s post, the two lines seem very closely correlated.  But on closer inspection there is a crucial difference.  Housing peaked by mid-2006, and declined thereafter.  That is why it is often viewed as a bubble.  High housing prices could not even be sustained in a relative strong economy during 2007.  In contrast, CRE prices peaked in early 2008, and fell only because the economy moved into recession.  There was a modest decline from 1.9 to 1.7 during the mild phase of the recession, and then prices fell sharply as soon as NGDP began declining in the second half of 2008.  This pattern is exactly what you would expect to occur during a period of tight money that caused the sharpest fall in NGDP since 1938.  Of course almost everyone else seems to think money wasn’t tight in 2008.  So what’s left when you have no other explanation for events?  A bubble.

The term ‘bubble’ is really just shorthand for saying; “I don’t know the cause.”

I don’t know the cause of the housing cycle.  Hence I can call it a bubble.  I do know the cause of the CRE cycle.  Hence I cannot call it a bubble.

Update:  I just noticed that Arnold Kling had a similar post.