November 2010invisible

Laufenberg Economic Quarterly

Daniel E. Laufenberg, Ph.D.
Economist

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

Executive summary

  • According to the preliminary estimate from the Bureau of Economic Analysis (BEA), real gross domestic product (GDP) grew at a 2.5 percent annual rate in the third quarter, following a downward revised gain of only 1.7 percent in the second quarter. Many market participates, as well as the policymakers at the Federal Reserve, are concerned that this slower pace of growth will persist, which helps explain the Fed’s decision to implement another round of quantitative easing (dubbed in the media as QE2).

  • The recovery has been slower than hoped but not sluggish. The U.S. economy has grown 2.9 percent at an annual rate over the first five quarters of the recovery, which may be slightly above its potential growth rate given that the unemployment rate is lower now than it was a year ago. I still expect the average annual rate of economic growth to accelerate somewhat over the next year or so, led by pent-up consumer demand, a slight rebound in housing, and further solid gains in business fixed investment.

  • Real personal consumption expenditures grew 2.8 percent at an annual rate in the third quarter compared with the 3.0 percent gain shown in the forecast in the August issue of the Laufenberg Economic Quarterly (LEQ). However, an upward revision to consumer spending in the second quarter put the average growth rate over the first three quarters of 2010 at 2.3 percent, slightly ahead of the average pace shown in the August LEQ forecast.

  • I expect consumer spending growth to accelerate somewhat over the next year, albeit in a very uneven pattern. Many of the changes in the tax code scheduled for the end of 2010 are expected to be temporary. Nevertheless, they still could depress consumer spending somewhat in the first half of 2011. Once many, if not all, of the Bush tax cuts are reinstated in 2011 and probably made retroactive to the first of the year, consumer spending will rebound.

  • Real final sales to domestic purchasers (a measure of final domestic demand for goods and services regardless of where the products are made) increased at an annual rate of 2.9 percent in the third quarter and 4.3 percent in the second quarter, for an average gain of 3.4 percent. This recent upturn in domestic demand may bode well for future real GDP growth.

  • Private payroll jobs have increased 1.1 million in the first ten months of the year, including the most recent gain of 159 thousand in October. Look for payroll job growth to improve further and for the unemployment rate to fall over the next year or so.

  • With the implementation of QE2, I fear that the Federal Reserve now is more concerned about the appearance of doing something than about the consequences of what they do. Inflation is benign for now, but the implication for future inflation is disturbing.

  • At this stage of the business cycle, interest rate risk is more of a concern than credit risk. Investors should be cautious but not afraid.

Forecast details

The Current Expansion: Sustainable but uneven

The forecast for the fourth quarter of 2010 and all of 2011 is little changed from the August issue of the Laufenberg Economic Quarterly (LEQ), even though real growth in the third quarter was less than I expected three months ago and the official estimate of real growth in the second quarter was revised downward. In particular, the Bureau of Economic Analysis (BEA) lowered its estimate of real gross domestic product (real GDP) growth in the second quarter to an annual pace of only 1.7 percent from its initial estimate of 2.4 percent, as well as estimating real GDP growth in the third quarter to be 2.5 percent at an annual rate rather than the 3.5 percent shown in the August LEQ forecast. The consensus has now come to expect real GDP to continue to grow at this slower pace for the foreseeable future. I disagree. Although there may be a quarter or two of slow growth ahead, the average pace of real GDP growth over the next year and a half, in my opinion, is more likely to surprise on the high side.

The key to this surprise will be a shift in final demand growth away from goods and toward services, the latter of which are more likely to be produced domestically than imported. Let me explain. According to the Bureau of Economic Analysis (BEA), even though real GDP grew at a 2.5 percent annual rate in the third quarter, real final sales grew a mere 1.2 percent. The implication is that the bulk of the growth in the economy in the third quarter came from businesses building inventories rather than from final sales. However, a closer look at the data suggests something more encouraging. That is, real final sales to domestic purchasers (which measure final domestic demand regardless of where the goods and services are produced) increased a more robust 2.9 percent in the third quarter; in the second quarter, this metric increased 4.3 percent whereas real final sales were up a scant 0.9 percent. In other words, final domestic demand growth was stronger than either real final sales or real GDP growth in recent quarters, as a large share of final domestic demand was satisfied with imported goods rather than domestically produced goods.

I contend that this is changing. The key will be a shift by consumers away from buying goods to spending more on services. A large share of consumer goods is imported, whereas consumer services are not. Thus, any slowdown in demand for consumer goods would be at least partially offset in the national income and product accounts by a corresponding slowdown in imports. Domestic demand would not necessarily have to grow faster for real GDP growth to accelerate as shown in the LEQ forecast. The only thing needed would be a shift in spending away from goods and toward services.

Fortunately, there was evidence in the BEA’s estimate of third-quarter GDP to suggest that this shift is already underway. For example, consumer spending on services, after adjusting for inflation, increased 1.6 percent in the second quarter and 2.5 percent in the third quarter. Although it does not sound very encouraging, it was the first time in over two years that service spending grew two consecutive quarters at a pace in excess of 1.0 percent. Also, the 2.5 percent increase in real service spending by consumers in the third quarter was the strongest percent gain since the fourth quarter of 2006.

There are other signs that spending on services are at a turning point. In particular, service employment has shown signs of improvement in recent data releases. According to the Bureau of Labor Statistics, private service payroll jobs in October were up 154 thousand from a month earlier and up 972 thousand through the first ten months of the year. Moreover, the employment index of the Institute of Supply Management non-manufacturing survey was 50.9 in October versus 50.2 in September, suggesting further improvement in service employment ahead. Finally, the wealth effect from higher stock prices most likely spurs consumer spending on services and durable goods more so than on nondurable goods. In fact, the largest impact of wealth on spending may be on services. Since March 9, 2009, the S&P 500 stock price index is up over 77 percent, providing a meaningful positive wealth effect on consumer spending because of both the magnitude and the duration of the gain.

For these reasons, the LEQ forecast continues to show a solid gain in real consumer spending in the fourth quarter. This, combined with a substantially smaller drag on real growth from net exports, should boost fourth-quarter real GDP growth well above its third-quarter pace. That being said, consumer spending and in turn real GDP growth may fizzle again in early 2011, owing to the assumption that higher tax rates will go into effect at the end of 2010. Nevertheless, many of the tax increases are expected to be repealed in 2011, probably in the first half of the year, and are likely to be made retroactive to the start of the year. As such, much of the hit to after-tax income early next year will be offset before year end. For this reason, the LEQ forecast shows real consumer spending growth in 2011 slowing to an average annual rate of less than 2.0 percent in the first half before accelerating to nearly a 4.0 percent average annual rate in the second half.

The one area of the August forecast that proved to be a major disappointment was housing. For the most part, I had expected that the bottom in housing was in the first quarter of 2010. As it turns out, the modest improvement in housing in the second quarter apparently was artificially induced by temporary tax credits. Once the credits expired, housing retreated again. In the absence of another round of temporary tax credits for first-time home buyers, the bottoming process for housing should be near the end.

As such, I am confident that housing starts will rise once the labor market improves. When households are formed, they demand housing. It seems that household formation was delayed because there were no jobs. The implication is that there is pent-up demand to form households once jobs improve. In other words, the temporary tax credit that was implemented earlier this year did not raise the overall level of housing demand but rather shifted demand forward. An improving labor market is needed before housing bounces off the bottom. I continue to believe that such an improvement is near. In the LEQ forecast, housing shows modest improvement over the next year, with starts expected to edge higher throughout the remainder of the forecast horizon.

Government spending will slow over the next year or so, but it will not slow enough to derail the solid hiring and spending gains expected in the private sector. The automatic stabilizers of fiscal policy make it unlikely that government spending slows very much given that the unemployment rate is expected to remain elevated over the forecast horizon. In other words, the unemployment rate, while still expected to decline to 8.2 percent by the end of 2011, remains well above the level considered to reflect full employment.

It’s now official—the recession ended in June 2009

On September 20, 2010, the Business Cycle Dating Committee of the National Bureau of Economic Research announced that a trough in business activity was identified to have occurred in the U.S. economy in June 2009. “The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II. Previously the longest postwar recessions were those of 1973-75 and 1981-82, both of which lasted 16 months.” 1 Of course, it was the longest recession since World War II because the committee determined that it started in December 2007. Not everyone agreed with this start date, primarily because at the time real GDP had peaked in the second quarter of 2008 and not the fourth quarter of 2007. Since then, as shown in Chart 1, revisions to the data now have real GDP peaking (just barely) in the fourth quarter of 2007, consistent with the timing committee’s original determination of the start of the recession.

Nevertheless, also shown in Chart 1, there is little doubt that the recession ended mid-2009. In announcing that the recession ended in June 2009, the committee noted that this inflection point does not mean that the economy is back to normal, just that the contraction ended and the expansion is underway. I agree with the committee on both counts. In the November 2009 issue of the LEQ, I wrote that “although it will be several months before the National Bureau of Economic Research, the group responsible for timing business cycles, declares the recession has ended, they probably will date the recession’s end sometime during the summer of 2009.”2

Of course, not everyone agreed with the NBER’s timing committee. One of the more famous to disagree was Warren Buffet, who claimed that his common sense told him that the recession was not over. Needless to say, people still do not feel great about the economy, but they seldom do during the recovery phase of the business cycle. There is always the concern that the economy cannot sustain any upward momentum it has, especially if the pace of such momentum is sluggish by historical standards. I recently came across an article written by Rhoda Fukushima in the Fresno Bee. In the article I was quoted to say that the “Recession is over” but that “It’s not your typical recovery.” “It’s very hard to detect, but it is still growth.” The date of the article was April 25, 1992. The NBER announced in December 1992 that the 1990-91 recession ended in March 1991.

In determining that a trough occurred in June 2009, the committee decided that any future downturn of the economy would be considered a new recession and not a continuation of the recession that began in December 2007. The basis for this decision was the length and strength of the recovery through the second quarter of 2010. Since then, third-quarter real GDP has been reported and it does nothing to contradict the view that the recovery remains intact.

Finally, a few jobs!

The one concern about this expansion, which was also the concern early in each of the prior two expansions, was the lack of new jobs being created. However, a jobless recovery this time is even more frustrating given the devastating loss of jobs during the last recession; as shown in Chart 2, nonfarm payroll jobs sunk a whopping 8.36 million from their peak in December 2007 to their trough in December 2009. So far this year, nonfarm payroll jobs are up 1.1 million, but are still 7.3 million below their peak in December 2007.

Although it may be too early to declare that the labor market has turned, October’s employment report contained some long-awaited good news. Not only did total payroll jobs increase 151 thousand in October, led by a solid 154 thousand gain in private service-producing jobs, but total payroll jobs in each of the prior two months were revised higher by a total of 110 thousand. Government jobs fell 8 thousand in October, following declines of 148 thousand and 144 thousand in September and August, respectively.

Other features of the establishment data used to measure payroll employment were also encouraging. For example, average weekly hours edged up one-tenth of an hour in October, which combined with the increase in jobs, pushed the total hours worked index up 0.4 percent from a month earlier and 2.4 percent at an annual rate from the average for the third quarter. Hence, even if labor productivity was flat in the fourth quarter, the gain in hours worked in October suggests that real output is already on track to increase 2.4 percent at an annual rate above the fourth quarter.

Not everything in the October labor report showed improvement. In particular, the civilian unemployment rate remained at its still elevated level of 9.5 percent. The August LEQ forecast expected the unemployment rate to be about 9.3 percent by now. Although I continue to expect the unemployment rate to drop nearly a percentage point over the next year, the downward stickiness of the rate so far this year does raise a few concerns. First, as shown in Chart 3, the unemployment rate did not peak until 15 months after the end of the 1990-91 recession and 20 months after the end of the 2001 recession. As such, many analysts expected—and some still do—the unemployment rate to rebound to a new high over the next few months. Obviously, I disagree. It looks as if the unemployment rate peaked at 10.1 percent in October 2009 and has edged slightly lower on average since.

Second, some suggest that without dramatic improvement in the unemployment rate, the current expansion cannot be sustained. And they are right, but not at this stage of the expansion. Each of the prior two expansions were much longer than average despite the unemployment rate continuing to rise well after the recessions ended. Early in the expansion, a falling unemployment rate is less important to the sustainability of the expansion than other factors, such as growth in payroll jobs and in final demand. In this case, it looks as if both have improved, albeit not quite as robustly as hoped. Moreover, the improvement in domestic final demand may be satisfied to a larger extent by foreign production than in prior expansions.

The bottom line is that the expansion will be sustained for now, regardless of whether the unemployment rate falls. Of course, for the expansion to continue beyond the first two years, solid job growth will be needed by then. At that time, jobs grow faster than the labor force, causing the unemployment rate to fall much like it did in each of the prior two expansions.

Third-quarter real GDP growth disappointing—for now

As noted earlier, real GDP grew 2.5 percent at an annual rate in the third quarter, well below the 3.5 percent pace shown in the August forecast, as well as my downward revised 3.0 percent estimate provided in my October commentary. In that commentary, I noted that residential investment (housing) was going to be a drag on rather than a contributor to real GDP growth in the third quarter. In fact, it was this component of real GDP that caused me to lower my estimate of real GDP growth to 3.0 percent from 3.5 percent.

Nevertheless, even at 3.0 percent, I was well above the consensus estimate at the time and, as it turned out, well above the BEA’s initial estimate of 2.0 percent. Since then the BEA has revised its estimate of third-quarter real GDP growth upward to 2.5 percent. For that reason, I reiterate my detailed view on economic growth in the third quarter and beyond.

I still contend that the economy is doing just fine and probably will do better over the next year or more than the consensus now seems to expect. In my October commentary, I noted that consumer spending, after adjusting for inflation, was “on track to increase at a 2.5 percent annual rate in the third quarter, up slightly from the 2.2 percent pace registered in the preceding quarter.”3 The BEA estimated that consumer spending increased 2.8 percent in the third quarter. This provides further support that consumers are making a comeback.

In the third quarter, business spending on equipment and software was expected to increase at a “somewhat slower pace than it did over the first two quarters of this year” but still “fast enough to allow the economy to sustain the recovery at a solid pace.”4 The 16.8 percent annual rate of gain was not quite as robust as anticipated, but business spending on structures came in better than expected. As a result, nonresidential fixed investment was roughly in line with my expectation. Residential investment was the big disappointment in the advance estimate and there is nothing in more recent data to suggest that this will change soon.

Real government spending was very robust in the third quarter, registering a gain of 4.0 percent at an annual rate. State and local spending essentially was flat, but federal spending jumped 8.9 percent owing to solid gains in both defense and nondefense expenditures. Although I agreed with the consensus that state and local government spending would falter, especially given their budget problems, I also noted that “state and local governments typically boost their capital budgets in the second and third quarters of an election year.”5 Thus, I did not expect government spending to retrench nearly as much as the consensus seemed to suggest. That being said, capital budgets cannot sustain state and local government spending, which means such spending most likely takes a much bigger hit in the fourth quarter of this year and early next year.

The big surprise in the BEA’s estimate of third-quarter GDP was the magnitude of the drag on growth coming from net exports (which are exports less imports). After detracting a whopping 3.5 percentage points from real GDP growth in the second quarter, I thought that net exports would detract “less than 1.0 percentage point” from real GDP growth in the third quarter.6 Instead, the BEA estimated the drag on real GDP to be 1.8 percentage points, due in large part to much faster growth in imports than I expected. Indeed, this miss in net exports alone can more than explain the difference between my estimate of 3.0 percent real GDP growth and the BEA’s preliminary estimate of 2.5 percent.

Finally, I had expected the change in business inventories to contribute as much as a 1.0 percentage point to real growth in the third quarter. Inventory accumulation added 1.3 percentage points, part of which probably reflected higher-than-expected imports. The implication was that this change in inventories, combined with the roughly 1.5 to 2.0 percent increase in real final sales, would result in real GDP growth of about 3.0 percent in the third quarter. Obviously, I missed somewhat on both counts, although the miss in real final sales growth was more pronounced.

Is there reason to be concerned? I believe it is prudent to always be cautious, but cautiously optimistic rather than fearfully pessimistic at this stage of the business cycle. After all, the economy has gone through a very difficult period; more difficult than anything that we have experienced in a very long time. Cautious behavior should be expected. Indeed, it should be encouraged, given that it was the absence of caution that got us into the mess in the first place. But we should not be fearful. Fear causes us to take no risk, whereas caution encourages us to take measured risks. I contend that we are taking risks, but they are very measured at the moment. For policymakers to expect more than that is foolish in my opinion.

Have we become QE addicts?

In its latest move to provide a boost to the U.S. economy, the Federal Reserve announced it will pump billions into the economy through a second round of quantitative easing, dubbed in the financial media as QE2. According to the plan, the Fed will buy $600 billion in long-term Treasury obligations over the next eight months. At first blush, this seems like a rather innocuous move on the part of the Fed at this stage of the cycle. After all, it has been sold by the Fed, at least in part, as a form of insurance that the U.S. economy does not enter into Japanese-style stagnation. Alan Blinder, former Vice Chairman of the Federal Reserve Board, noted in a recent CNBC interview that the economy most likely would recover without QE2 but that the benefit of QE2 is that it would accelerate the recovery process. Moreover, the Fed and its many supporters contend that it can and will unwind QE2 in time to avoid any inflation problems.

If it was that easy, then I would not be concerned. Alan Blinder suggests that the Fed policymakers are smart enough to know when to reverse course. I do not question Professor Blinder's statement that the Fed policymakers are smart, but I do question their ability to reverse course in a timely manner. Recall that there were a lot of smart guys and gals who got us into our past financial and economic crises.

First, supporters of QE2 contend that it is no different from the traditional channel of monetary policy. That is, the Fed buys Treasury obligations to force interest rates lower. The difference with QE2 is that the Fed is buying longer-term Treasury obligations rather than Treasury bills only. One difference this makes is that when the Fed buys T-bills it has considerable influence over short-term interest rates, which in turn provides valuable feedback to help the Fed monitor its policy decisions. No such feedback exists when policymakers deal in longer-term obligations. The reason is that the Fed may be buying on one hand in an effort to drive longer rates down, but if investors are concerned that the Fed’s actions eventually will be inflationary, then longer rates actually may rise. Higher long-term rates would be counter to the Fed objective, causing them to engage in more QE.

Second, there is a bit of a conflict between the Fed’s goal of lowering long-term interest rates by limiting the supply of long-term Treasury obligations in the market and the U.S. Treasury’s goal of lowering borrowing costs by taking advantage of historically low rates at the long end of the yield curve.7 This may complicate the effect of QE2 on longer-term interest rates, on future inflation and inflation expectations. As such, any positive effect on the real economy is very small at best. As a result, the potential cost to the U.S. economy in terms of future inflation far outweighs the benefit to growth in the near term.

I fear that the Federal Reserve now seems more concerned about the appearance of doing something than about the consequences of what they do. I agree that the implementation of QE2 most likely will not hurt the recovery in the near term and in fact may “accelerate it” as Alan Blinder argues. However, an accelerated recovery does seem to have a serious drawback—bottlenecks tend to appear that cause inflation to accelerate sooner as well. This becomes an even greater concern for future inflation if we have become QE addicts. I worked at the Federal Reserve Board in Washington, DC from 1973 to 1987, fourteen years of inflation fighting of various degrees. I am very confident that the Fed knows how to fight inflation. However, the fight against inflation can be very painful if we let it advance too far, too quickly before the Fed begins to reverse course.

Investment implications

In the near term, the expansion continues, albeit in an uneven pattern over the next few quarters. Moreover, the pace of the expansion on average over the next year or so is expected to be fast enough to absorb enough capacity to allow the unemployment rate to fall and inflation to edge a bit higher, but not fast enough to cause inflation to climb to a level that would threaten the expansion. As such, the Fed is expected to be very slow and gradual about changes in monetary policy through 2011. In fact, the Fed will not start unwinding its current accommodative policy stance until investors view it as necessary to avoid future inflation. My only concern is that by then it will be too late to prevent inflation from rising to a level that does threaten the expansion.

At the moment, my best guess is that inflation does not become a threat to the expansion until 2014-15. In other words, the next recession is still several years away, which means there is still plenty of time to own corporate and municipal bonds, as well as equities. Interest rate risk is more likely to become a problem before credit risk, which means that sovereign debt initially gets hit harder than private debt when interest rates do start to rise.

______________________________

1 See Latest Announcement Relating to Current Business Cycle, Business Cycle Dating Committee, National Bureau of Economic Research, Cambridge, MA, September 20, 2010.

2 See Daniel E. Laufenberg, “Recovery underway,” Laufenberg Economic Quarterly, November 2009, pp. 5-6.

3 See Daniel E. Laufenberg, “What’s going on?,” Commentary posted on laufenbergquarterly.com, October 15, 2010.

4 Ibid.

5 Ibid.

6 Ibid.

7 A similar conflict between the goals of the Fed and the Treasury existed when the Federal Reserve engaged in what was dubbed at the time as “operation twist’ policy from 1961-65. It was called “operation twist” because the Fed was trying to twist the shape of the term structure of interest rates—raise short rates and lower long rates at the same time. Higher short rates were expected to attract foreign capital and reduce the balance payments deficit, while lower long rates were expected to help boost economic growth. This policy was implemented at a time when currencies were fixed, not floating as they are now, and international payment deficits were paid in gold.

Causes of the financial crisis revisited

[This essay is based on comments made at Iowa State University, Ames, IA on Thursday, October 28, as a member of a panel to discuss “Fixing Financial Markets: Views from Freddie, Finance and the Fed.” The other members of the panel were Donald J. Bisenius, Executive Vice President of the Single Family Credit Guarantee Business at Freddie Mac, and Kevin L. Moore, Senior Vice President in charge of the Supervision and Risk Management Division of the Federal Reserve Bank of Kansas City.]

The severity of the recent financial crisis has already generated a flurry of academic papers and books, and I am confident that more will follow, attempting to identify the various causes of the crisis. So far, the suggestions include the trade deficit, rapid growth and collapse of housing prices, general decline in mortgage underwriting standards, widespread mismanagement of risk, and excessive leverage by households. Although all happened, I contend that they represent symptoms of the crisis rather than the causes. In that regard, if we hope to avoid another financial crisis of this sort, we need to know the causes. I believe a more macro view of the crisis narrows the field of candidates considerably. From that vantage point, and with the benefit of hindsight, the crisis appears to have been the culmination of over twenty years of misguided federal housing policy and an overly accommodative monetary policy.

People respond to incentives. Over the last twenty years, the housing policy implemented through the tax code and the various financing agencies sponsored or supported by the federal government, in an environment of low and falling interest rates, incented many to view their house as tax-advantaged collateral more so than a source of shelter. Under those circumstances, it should be no surprise that home prices soared to levels clearly inconsistent with economic fundamentals, that politicians saw the situation as an opportunity to expand homeownership, that financial institutions created new products to help finance house purchases, and that lenders become giddy with the returns they thought were low risk. This situation persisted as long as the tax advantages of homeownership had value, the price of the home increased, and interest rates remained low. In 2006, house prices stopped increasing, which in turn eroded the market value of the tax advantages of homeownership.

The federal housing policy implemented over the years was based on the good intention that home ownership makes people better citizens because such ownership provides them a vested interest in their community. As homeowners, they are more likely to promote safe neighborhoods and support good schools and decent roads. The policy objective was not to encourage people to buy houses because they provided a tax-advantaged way to use someone else’s money to realize a quick buck (tax free) by selling the houses for more than they paid for them, or because the house could be used as collateral for a low-interest rate, tax-advantaged loan. For the most part over the last 20 years, housing policy has encouraged too many people to buy a house for the latter reason rather than the former.

The opportunity to misuse housing and mortgage debt was available for a long time. So why did it become so widespread and so blatantly excessive in this decade?

I contend that it started with the Tax Reform Act of 1986, which made interest paid on mortgages the only interest deduction for households on their federal tax returns. Up until then, all interest payments by households were tax deductible. With this tax advantage extended only to mortgages and in turn homeownership, why did housing starts collapse in the late 1980s? The reason was that passage of the Tax Reform Act of 1986 repealed many tax shelters available for passive investments in multi-family housing and commercial real estate. This reduced the value of such investments which had been held more for their tax-advantaged status than for their economic fundamentals.1 This contributed to the end of the real estate boom of the early to mid '80s and facilitated the Savings and Loan crisis. As shown in Chart 1, the bulk of the drop in real estate in the late 1980s was in multi-family housing and retail and office properties; single-family housing held up reasonably well until the recession of 1990. A reason single-family housing did so well during the real estate crisis of the late 1980s was the fact that it was the only tax-advantaged real estate play still available.

This advantage was enhanced in 1996, when up to $500,000 of capital gains realized on the sale of a house was free from federal income taxes. Relative to other investments, the after-tax return from owning a home was enhanced. And since some homeowners were buying houses with little or no equity, the potential after-tax return on that equity was even more. In other words, the incentive was to leverage up the house as much as possible at the time of purchase in the hope that the price of the house would go up. Rather than take advantage of the preferential capital gains tax treatment of their house, others used the equity that they did accumulate in their house as collateral against loans to finance a wide range of activities, not just home improvement. This was very easy to do, through the use of home-equity lines of credit, home equity loans, or mortgage refinancing, especially in a low and falling interest rate environment. In other words, not only were the interest payments tax deductible, but the rate of interest on such loans was far below what households would pay for an unsecured loan, such as a credit card, or even a secured auto loan from a bank.

Some contend that the increasingly accommodative housing and monetary policies that have been in place for years has accomplished their objective of increasing homeownership. For example, in the fourth quarter of 1986, 63.9 percent of households owned their home. This ratio rose to 65.4 percent by the fourth quarter of 1996 and to a peak of 69.2 percent at the end of 2004. Since then, this ratio had slipped somewhat to 66.9 percent. Clearly, the ratio of homeownership did get a boost early in this decade but the bulk of the increase in this ratio since 1986 can be explained by changing demographics. In particular, the aging population may have more to do with the upward trend in homeownership than a more accommodative housing policy. After all, roughly 80 percent of householders aged 55 years and over own their house versus about 40 percent of householders aged 35 years or younger. With the first of the baby-boomers turning 65 in 2011, it should be no surprise that this ratio has moved higher over the last 20 years.

The spike in ownership in 2004 most likely was driven in part by new products that made home ownership appear to be more affordable but was distorted because the price of these products did not fully reflect the risk. Moreover, the special tax treatment of capital gains on housing clearly is more valuable when house prices are rising than when they are not. This created a bit of a vicious circle in that higher house prices increased the value of tax-free capital gains on housing, which in turn pushed house prices even higher.


Source: Census Bureau

Hence, housing policy in the U.S. probably did more to promote higher house prices than it did to promote homeownership. Preferential tax treatment of a particular asset eventually is reflected in the price of that asset. Canada may provide an example of this. Canada does not offer the same tax advantages to debt financed home ownership offered in the U.S. The Case-Shiller and Teranet series indicate that over 2000–2006, U.S. prices appreciated nearly twice as much as Canadian houses.2 Indeed, the price of a square meter of housing in major cities in Canada is far less than the price of a square meter of housing in U.S. cities, yet the percent of households that own a home is very similar—66.9 percent in the U.S. versus 67 percent in Canada. In other words, the tax advantages to home ownership in the U.S. appear to promote higher house prices rather than increased ownership.

Of course, borrowers were not the only participants in the events leading up to the financial crisis. Investors also were key players. They were incented to participate in framing the crisis by stretching for more return in a low interest rate environment. Investors wanted more income and often misunderstood or underestimated the risk associated with that higher income flow. Because interest rates were so low across the entire term structure, the only way to generate more return was for investors to take on more risk. In their effort to stretch for return, investors became increasingly interested in the “subprime” mortgage market.

Given the key role played by the “subprime” market in the financial crisis, the question is why the Canadian subprime market was both smaller and levels of securitization were lower than in the U.S. While it is difficult to disentangle the reasons why Canada avoided the subprime boom, some factors can be identified that may have contributed to the differences in the Canadian and U.S. subprime markets.

Although the subprime share of the Canadian market was small, it was growing rapidly prior to the onset of the U.S. subprime crisis. In response to the U.S. crisis, some subprime lenders exited the Canadian market due to difficulties in securing funding. In addition, the Canadian government moved in July 2008 to tighten the standards for mortgage insurance required for high loan-to-value loans originated by federally regulated financial institutions. This further limited the ability of Canadian banks to directly offer subprime-type products to borrowers.

There are also several institutional and regulatory details of housing policy in Canada that played a role. The Canadian market lacks a counterpart to Freddie Mac and Fannie Mae, both of which played a significant role in the growth of securitization in the U.S. In addition, bank capital regulation in Canada treated off-balance sheet vehicles more strictly than the U.S., and the stricter treatment reduces the incentive for Canadian banks to move mortgage loans to off-balance sheet vehicles. Finally, as noted above, the fact that the government-mandated mortgage insurance for high loan-to-value loans issued by Canadian banks effectively made it impossible for banks to offer certain subprime products. This likely slowed the growth of the subprime market in Canada, as nonbank intermediaries had to organically grow origination networks.3

Freddie Mac and Fannie Mae, with their implied government guarantee, have done much to promote the securitization of mortgages. Providing direct access to capital markets for mortgage originators rather than going through a traditional financial intermediary promoted financial engineering and helped spawn “the shadow banking system” in the U.S. One example of shadow banking was called the structured investment vehicle (SIV), which was invented by Citibank in 1988. Essentially, a SIV funded the acquisition of asset-backed securities with the issuance of commercial paper. It earned profits on the spread between the cash flow (principal and interest payments on the assets) and interest payments on the high-rated commercial paper that it issued. A financial vehicle called a SIV should have been suspect from the very beginning.

The conclusion is that everyone acted in their own best interest leading up to the financial crisis given the incentives that were in place at the time. I would argue that we need to be more careful going forward about creating such incentives. Allow decisions to allocate economic resources to be based on fundamentals rather than tax or political factors.

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1 Prior to 1986, much real estate investment was done by passive investors. It was common for syndicates of investors to pool their resources in order to invest in property, commercial or residential. They would then hire management companies to run the operation. TRA 86 reduced the value of these investments by limiting the extent to which losses associated with them could be deducted from the investor's gross income. This, in turn, encouraged the holders of loss-generating properties to try and unload them, which contributed further to the problem of sinking real estate values.

2 See James MacGee, “Why Didn’t Canada’s Housing Market Go Bust?,” Economic Commentary, Federal Reserve Bank of Cleveland, December 2, 2009.

3 Ibid

LQ Stock-allocation indicator

In the August 2010 issue of the Laufenberg Economic Quarterly, I introduced the LQ stock-allocation indicator.1 The purpose of this indicator is to provide a signal of when to overweight or to underweight equities in well diversified investment portfolios. In the August issue, the indicator suggested that investors should overweight equities in their portfolios. Based on three more months of data (see Chart 1), it continues to suggest the same.

Although the S&P 500 stock price index has increased 14 percent since August, signaling such short-term moves in the stock market is not the purpose of this indicator. The LQ indicator is not a trading tool. Its purpose is more long-term. In other words, if the signal provided by this indicator is followed, well-diversified portfolios should outperform the buy-and-hold strategy, as well as the dollar-cost-average strategy, over a decade and not a week, month, or even a year.

As noted before, the LQ indicator seems to move counter to the S&P 500 stock price index—when the indicator is low, stock prices are high, and vice versa. But there is more information in this indicator than the obvious. For example, when the indicator pushes above a reading of 100, it signals a time to overweight equities in your portfolio. This was true in 2002 and again in 2009, when in both cases the indicator moved through 100 just a few months before the S&P 500 stock price index bottomed. In addition, the indicator provides a signal to investor to underweight equities. This signal is not as defined as the signal to overweight. It occurs when the value of the indicator has stabilized over an extended period following a pronounced decline. Certainly, investors could sell equities as the indicator falls, but they would be better served to wait until the indicator has leveled off at a lower level. This signal was provided by the indicator twice over the last twelve years, once in 1999-2000 and again in 2007. Based on its latest observation, the indicator suggests that investors can still get paid to be overweight equities.

It goes without saying that there is no guarantee this relationship will hold in the future. Indeed, a major concern may be that there are too few cyclical observations (only two business cycles shown) to claim that the indicator accurately signals the cyclical element of the stock market. For this reason, I would caution readers not to rely on this indicator without reservation. On the other hand, do not dismiss it either. In analysis of this sort, the signal from one indicator should be verified using the signals of other indicators that attempt to measure the same event in a different way. It should be viewed as another tool to assist investors in making their asset allocation decisions.

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1 See Daniel E. Laufenberg, “The economic expansion continues—really!,” Laufenberg Economic Quarterly, August 2010, pp. 10-11.

 

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


ARCHIVES OF LAUFENBERG ECONOMIC REPORTS

November 2009 - LEQ (PDF)
February 2010 - LEQ
May 2010 - LEQ

August 2010 -LEQ


INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

The Current Expansion: Sustainable but uneven

Causes of the financial crisis revisited

LQ Stock-allocation indicator

~ ~ ~ ~

INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

The Current Expansion: Sustainable but uneven

Causes of the financial crisis revisited

LQ Stock-allocation indicator

~ ~ ~ ~

 

INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

The Current Expansion: Sustainable but uneven

Causes of the financial crisis revisited

LQ Stock-allocation indicator

~ ~ ~ ~

 

 

 

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