Friday, April 27, 2018

Wage pressure is not inflationary.

The employment cost index for the first quarter continues to show some moderate strength.  This has led to new discussion about inflation, etc.

I have written a few posts about the Phillips Curve - the idea that wage growth and inflation are related, or that rising wages lead to rising inflation.  I don't think this relationship works the way it is generally described.  Monetary inflation should certainly cause wages to rise just as it should cause all price levels to rise.  Clearly there is causation going in that direction.  I think the apparent causation going in the other direction is misleading.  It is a matter of only feeling parts of the elephant.

One main piece of evidence that makes it look like rising wages lead to inflation is that firms report tight profit margins that are being squeezed by rising wages.  They either have to raise prices or reduce profits.  It seems likely that this would produce price pressure.  The idea of cost-push inflation is alluring, but not useful.

First, there are two potential sources of wage pressure.

1) Rising capacity utilization.

2) Fundamental productivity growth.

On point 1, as unemployed workers return to the labor force and the pool of potential workers declines, there are pressures on wages.  But, an economy running below capacity is not a productive economy.  In this context, both wages and profits should rise, but this should be more than compensated for by the boost in productivity caused by utilizing productive capacity.  Wage and profit growth should be real, in this context.  If anything, this sort of growth should be disinflationary as real growth would be strong.

On point 2, it is difficult to grasp in real time the full complement of mechanisms that are in play.  And, we will be more likely to see ailing, dying industries that we are familiar with than new, disruptive industries that are the source of new productivity.  Here, also, it will appear that rising wages are inflationary, but they are not.

Here, it might be useful to think of Amazon vs. brick and mortar book stores.  Wage growth was strong in the late 1990s, and it would have been tempting to look at rising wages at brick and mortar book stores, and to forecast inflation.  That is because those were mature businesses, so they had a very stable and understandable cost structure.  Wages were rising, and they either had to raise prices or lose profits.

But, what we were seeing there wasn't price pressure.  What we were seeing was productive transformation in an economy.  What we were seeing was the end of a business model that wasn't profitable any more.  When any business model comes to the end of its life because of new innovation and productivity, it will look like it is suffering from cost pressures.   But, to the extent that those cost pressures were acute, they simply led to the transformation to new, more productive business models.

Amazon, on the other hand, was hiring like mad.  And, nobody was looking at Amazon as a source of inflationary wages.  That's funny, really.  Because, since Amazon was young, they were not particularly profitable themselves.  But, nobody looks at a young, disruptive company and says, "Oh, labor costs are cutting into their profits, this could lead to inflation."  That's because Amazon wasn't trying to become profitable by cutting costs.  They were trying to become profitable by hiring and growing.

There was a lot of that going on in the late 1990s.  So, profits were low, wages were growing, and inflation was moderating.  And, the stock market didn't seem too put out by the whole state of affairs.

By the way, interest rates were also high at the time, but they weren't high because the Federal Reserve was trying to discipline risk-takers by sucking cash out of the economy.  They were high because investors were risk-takers, and so the safety of fixed income was not highly valued at the time.  The appetite for risk wasn't expressed through borrowing.  It was expressed through Amazon's rising stock price.  It was expressed through expanding equity, not debt.

Rising wages are a sign of progress.  They are something to be encouraged, not tempered.  When wage growth is strong, real interest rates might naturally rise, but there is no reason to try to force them to in order to stop the business cycle.

Thursday, April 26, 2018

An unleveraged banking experiment.

I have written previously about my own confusion regarding the issue of bank capital.  The issue seems largely rhetorical to me.  It comes down to whether you call deposits capital, in which case you're an unleveraged money market fund, or you call deposits liabilities, in which case you're a bank.  The difference seems to be that insuring deposits turns them into liabilities.

There are so many debates in finance that seem to me like they could be solved simply.  Too big to fail could be solved by using private deposit insurance instead of public insurance, which would lead to prices that reflect risk.  Even with public insurance, I'm not sure what's stopping us from simply pro-rating insurance fees to reflect changing capital levels or size.  Money market funds seem to do just fine.  To the extent that there is some risk in NAVs falling below $1, it seems to me that a standard contract for investors could have a clause that if NAV ever falls below $1, then withdrawals must pay an additional 1% fee.  This would be a fairly insignificant amount, it would reduce panic withdrawals, and to the extent that there were still withdrawals, they would naturally push NAV back above $1.  In the rare event that this happens, it seems like this would be a stabilizing policy with little cost to investors.

I am sure that I am naïve on these matters and there are good reasons why some of these ideas aren't used.

But, regarding bank deposits, I would like to imagine a system with 100% capital requirements.  Instead of making deposits, depositors would just buy shares in the bank.  The returns depositors earn would not change much, because today depositors make up a very large portion of the capital available to banks, so the returns that currently go to equity holders would be spread pretty thin when shared among the new depositor/shareholders.

But, depositors want certainty.  In this regime, they could get certainty by selling at-the-money puts on their shares.  Depositors would make deposits or withdrawals by buying or selling shares.  The bank would mediate their asset base by buying and selling shares on the open market.  So, sometimes, withdrawers would be selling shares to depositors and sometimes they would be selling to the bank.

This would be a 100% capitalized banking system.  The put sellers would basically be taking the role that today's equity holders take, but with much less volatility because even failed banks usually only have capital shortfalls of a few percentage points of their assets.  In today's system, equity in a failed bank would fall to $0 if the value of assets fell below the value of liabilities.  This system would be more like a money market fund.  A failing bank whose shares had sold at $100 might now sell for $98.  Depositor/shareholders would exercise their puts, and the put sellers would now be shareholders.  The depositor/shareholders wouldn't lose a penny, and they would be free to reinvest their $100 back into the same bank at $98 per share or into another bank.  The main factor determining that decision would be how high the put premium was.  If a lack of confidence led to a run on shares, the bank could recapitalize by buying shares at the market price if that price fell below NAV.  The only losers would be the put sellers.

There could even be a public agency through the Fed that was a major put seller.  This would create a natural method for recapitalizing banks during nominal financial crises, because depositors would buy shares in other banks, and when the Fed funded exercised puts, it would be a natural monetary injection into the system that was automatic and didn't require discretionary decisions about which institutions to support.  Of course, this whole system would work better with some moderate inflation so that share prices tended to have an upward trajectory and exercised puts weren't triggered frequently.

In a way, this wouldn't be much different than today, where the Fed owns a bunch of treasuries and also holds reserves that they pay interest on, and monetary policy comes from managing both of those quantities.  In this system, they would earn income on treasuries they own and on puts they sell, and they would manage the quantities of treasuries and bank shares that they own from exercised puts.  It would sort of be a nationalization of the commercial banking system, because as a put seller, the Fed would basically be taking the risks that current bank shareholders take.

Today, banks are induced to take risks because the upside flows to shareholders.  In this system, that upside would still exist, but it would have to be earned through put premiums as income.  Riskier banks could offer shareholders higher dividends, but it would come with higher put premiums.  Maybe seeing that bank share prices rarely declined by more than a couple percentage points, few depositor/shareholders would even bother buying puts.

Since upside profits would be retained by the depositor/shareholders, put sellers would have less potential upside than today's bank shareholders do, but that would also translate into less downside risk.  They would mainly be trading a regular income stream for the occasional shock.  The main regulatory issue there would be how much leverage put sellers would be allowed to utilize when they sold puts.

Anyway, this is all academic.  But, I like to think about these sorts of things using a different rhetorical framework to try to think more clearly about these issues in a way that separates rhetorical factors from real factors.  Limiting ourselves to the rhetorical frameworks we generally accept seems like it leads to limited solution sets and to solutions that solve rhetorical problems when really, what we need are solutions to real problems.

I hope you haven't found this brief post to be a waste of time.  I welcome comments that point out how ill informed this post is.

Wednesday, April 25, 2018

Housing: Part 294 - Rent inflation in the UK vs. the US

Here is an interesting article about home prices and housing costs. (HT: NinjaEconomics)   It's titled, "How economists (should) think about the housing market", and I think it is correct.  The author, Ian Mulheirn, points to rent as the key factor to look at regarding housing affordability and supply/demand.

He is talking about the UK, and in the UK, he presents compelling evidence that there is abundant housing. This means that low interest rates are the reason for high home prices in the UK, not a lack of supply.  Here, in another article, he argues that the number of homes has risen more than the number of households, and that changing incomes have outpaced changing rents.  Here is a figure from that article.
There are a couple of points to be made here about the US market.

First, this is clearly not the case here, and in fact, this is at the heart of how our self-imposed financial crisis is the primary factor that makes us different from other countries.  We imposed a credit crisis on ourselves, inducing a decade-long housing depression.  So, our supply is certainly low, and our rents are rising.

Second, one of the reasons we got it so wrong and imposed such damaging policies in the US is because this was not the way the housing market was addressed in the US.  Rent had been high, nationally, after the mid-1990s, and it was especially high in the cities where prices were high.  The supply signal really was there in the US.  Yet, the conversation was maniacally focused on credit markets.

Third, this points to a subtle difference between rising prices in the US versus other places.  I think the analysis here would apply to Sydney, Toronto, and Vancouver, too.  I think that in those countries, total homebuilding has been adequate, and nationally, rent levels have been moderate.

Notice that London, here, looks like it has been roughly in balance regarding housing costs.  But, in the context of the broader UK housing market, I think there are countervailing forces.  UK building has been strong, and that has brought rents down in many places.  This is exactly what was happening in the US before 2007.  Rents were declining in places like Texas and Georgia because generous lending and low real long term interest rates were inducing more building.  Our mistake was seeing that as a threat instead of a source of stability and progress.

So, in much the UK, rents are low.  Now, at the same time, there are two other things happening.  First, low interest rates are raising the prices of homes across the UK, so that looking at prices, affordability looks much worse than if we look at rents.  That shouldn't matter.  It is rent that is important regarding affordability.  But, Mulheirn is right that, in this case, high prices aren't a sign of a shortage of supply.

But, notice that, while London looks well balanced in isolation, in comparison to the rest of the UK, it is an outlier.  So, the same sorting migration is happening there as is happening in the US.  London is still relatively more expensive than other areas, so there is a bidding war for London residence.  In the US, in 2005, the migration induced by that difference was strong enough to create bubbles in Arizona and Nevada.  Part of what was keeping rents lower at the time was the abundance of housing outside the Closed Access cities.

I think part of the difference between the US and other countries is that the US Closed Access cities are worse than their international counterparts.  One figure in Mulheirn's articles shows unit growth in London as on par with growth in other places.  This is definitely not the case in the US.  So, when low interest rates induced more building in the US, and induced expanded housing consumption among young aspirational workers in the Closed Access cities, those cities had to depopulate.  This led to the contagion that hit Arizona and Nevada.  Toronto, London, Sydney, etc., seem to be more like cities like Seattle.  They allow a reasonable amount of building, but it still isn't enough to handle the new wave of urbanization.

So, the international cities, like Seattle, still have relatively high prices.  They still have rent inflation that is higher than in cities like Dallas.  But, the problem isn't severe enough to induce a disruptive migration event.

So, in Toronto, Vancouver, London, Sydney, etc. it is reasonable to say that high prices are largely a result of low real interest rates.  But, more housing supply would still make the situation better, just as the country would be better off if Seattle could add units at the same rate that Atlanta or Dallas does.

In the US, we have a different issue than the UK.  We do have rising rents, and we have kept prices down through credit repression.  So, if we lifted the credit repression, we would have an affordability problem, both in terms of rents and prices, but that is the only functional way of solving the supply problem that has produced higher rents.  Continuing to remove the income tax benefits of owner-occupiers would help in that regard.  But, credit access for middle income buyers and new buyers would need to recover, and that would be related to sharp price increases in low tier markets.  A healing market would depend on that development happening without freaking out policymakers.

Saturday, April 21, 2018

Welcome the robots.

There is a never ending debate about whether automation will eventually create problematic unemployment.

The same fears have been around since the dawn of the industrial revolution.  If you wanted to suggest to a farmer in 1840 that he and almost everyone he knew would become obsolete, and it would be overwhelmingly for the better, he would have been unpersuaded, if not downright angry.

Likely, he would have hastily demanded an answer to the question, "What in the world would you have us all do to earn a living?"

You could, quite reasonably, have answered, "Well, maybe instead of farming, people could do air ballet for strangers, and, I don't know, sell tickets or something."  Or, just as reasonably, you could have described most of the jobs at Google, or, or many other firms in today's economy.

The farmer would, understandably be non-plussed.  It's not just that you would have a hard time explaining what you meant to him.  It's that there would be no way to get him from point A to point B.  The explanation would have simply been beyond his imagination.

This is what growth means.  It means that things we take for granted are replaced with things we can't imagine.  Luckily, we can imagine air dancing today.  Automation and healthy economic growth will bring new things we can't imagine.  I would like to eventually take for granted the things that today I can't imagine.

It is true that there are jobs because there are needs to be met.  It is also true that there are jobs because there are people looking for needs to meet.  Unemployment is a function of frictions over limited time periods, not of a lack of demands.  This is so clear, it is strange that we have to remind ourselves of it.  Certainly the places where the most broad supply of services are available are not the places where there are more people lacking in available productive activity.  The opposite is clearly more true.  There was a time when this person, looking for needs to meet, would have mostly been looking at a potential set of needs that required leading oxen through a field or some such activity.  Today, that set is large enough to include air dancing.

Should we want change and growth?  To answer yes requires that we cease to rely on our imaginations.  It is an explanation destined to lose, and so we will likely be relitigating it, still, a century from now, when air dancers ask, indignantly, "Well, then, if you invent better holographic robot dancers, what in the world are we supposed to do?"

Wednesday, April 18, 2018

Housing: Part 294 - More doubt about the reckless subprime lending story

Here is the abstract to a paper by Ospina and Uhlig:
We examine the payoff performance, up to the end of 2013, of non-agency residential mortgage-backed securities (RMBS), issued up to 2008. We have created a new and detailed data set on the universe of non-agency residential mortgage backed securities, per carefully assembling source data from Bloomberg and other sources. We compare these payoffs to their ex-ante ratings as well as other characteristics. We establish seven facts. First, the bulk of these securities was rated AAA. Second, AAA securities did ok: on average, their total cumulated losses up to 2013 are 2.3 percent. Third, the subprime AAA-rated segment did particularly well. Fourth, later vintages did worse than earlier vintages, except for subprime AAA securities. Fifth, the bulk of the losses were concentrated on a small share of all securities. Sixth, the misrating for AAA securities was modest. Seventh, controlling for a home price bust, a home price boom was good for the repayment on these securities. Together, these facts provide challenge the conventional narrative, that improper ratings of RMBS were a major factor in the financial crisis of 2008.   (HT: Tyler Cowen)

Arnold Kling disagrees about the conclusion.

Monday, April 16, 2018

Housing: Part 293 - How has Dodd-Frank hurt low tier housing?

I have asserted that Dodd-Frank has been especially damaging to low tier housing markets in the US.

How is this damage inflicted?

First, the data that triggers this conclusion clearly points to specific market segments as the sign of the problem.  Much of Dodd-Frank deals with banking regulations, in general.  If generalized regulations were at work here, then the effect would ripple throughout housing markets, and new entrants would find a way to issue profitable mortgages.  But, starting in the summer of 2010, with the passage of Dodd-Frank, there was a diversion in market values between top tier and bottom tier homes in many cities.  This isn't an effect on lending in general.  It is an effect on lending to homes with lower market values.

Much of the debate about Dodd-Frank revolves around those general regulatory issues.  And, as with all things housing, since there has been an erroneous consensus that bank recklessness caused a bubble followed by an inevitable bust, the premises that the consensus has been built on have defined the debate about Dodd-Frank.  Those premises include the basic presumption that home prices have generally either been correct or too high, and that drops in home prices should be generally regarded as a return to normalcy while rising prices portend danger.  These premises were so strong, that they led everyone to miss a generational defining policy error that has sapped 20% or more of market value from low tier homes in many cities.  So many problems could have been solved by simply allowing that value to be re-attained.

Not only has the peculiar shape of this dislocation gone largely unnoticed, its resolution has been ignored or even actively avoided, as when Fed officials note that rising asset prices create an additional concern for accommodating monetary policy, even as low tier housing markets are so eviscerated that homebuilders can't even fund the purchase of lots to build them on.  (Builders seem to view this as a "shortage" of lots.  Others seem to think builders are just blind to the existence of a market that they were supposedly over-supplying 12 years ago.  All of these problems would go away if we stopped imposing a 20%+ discount on the end product.  But, a 20% increase in home prices would trigger public consternation and a policy response.)

In any case, the generalized regulatory targets of Dodd-Frank have little to do with the damage it has inflicted on working class housing markets.  I think the damage has mostly come through the Consumer Finance Protection Bureau and the regulation of "ability to pay" through the Qualified Mortgage program.  (Here is a sense of the vague liabilities the law imposes.  From the link: "Your lender gets certain legal protections when showing that it made sure you had the ability to repay your loan. Even with these protections, you may still be able to challenge your lender in court if you believe it did not make sure you had the ability to repay your loan.")

CFPB oversight applies to both banks and non-banks.

The problem seems to play out through a combination of higher regulatory requirements and higher costs, together with limits on the amount of fees lenders can charge to help cover those costs (examples 1 , 2 , 3 ).  The correlation of price behavior with Dodd-Frank passage suggests that higher fixed costs have made smaller mortgages difficult to fund.  The "ability to pay" standard may be a primary influence here, or maybe it is simply the cost of establishing the ability to pay that prevents mortgages on smaller properties from being funded.

The rise in homeownership before the crisis had been among young households with high incomes, education, etc.  The decline in homeownership since then has also been focused on both young families and families with lower incomes.  So, the net result of the boom and bust has been to reduce homeownership among households with below median incomes.  Yet, the largest drops in homeownership have been among households under 45 years of age, even if they have high incomes.  The constraint seems to be hitting low tier- and starter home markets, in general.

The drop in lending to lower FICO scores seems to have happened earlier, when the CDO panic happened, the financial crisis hit and the GSEs were taken over.  There isn't any further shift in originations with Dodd-Frank.  There isn't any obvious shift in the rate of delinquency or foreclosure, either.  Yet, there is this shift in pricing behavior that happens coincidentally with the passage of Dodd-Frank.  The effect of Dodd-Frank seems correlated with the market value of the property.  And, this shift in prices should be surprising.  If it hadn't been swamped by the scale of everything else that had happened, it should have led to much public concern.

In a way, I am simply applying the same type of analysis that has been applied to mortgage markets during the boom.  Researchers used changing prices to infer the effect of credit supply.  There were forms of credit which were more flexible than they had been previously.  At about the same time, it seems that prices in low-tier housing markets increased.  It is difficult to attribute price changes to each individual lending decision, so the connection was inferred.

I am doing the same thing here.  There was a shift in public policy - here that had the explicit goal of removing credit access from certain borrowers.  A price shift happened at the same time.  There are mechanisms that could create that shift, mainly in the regulations through the CFPB relating to qualified mortgages.  I am inferring a connection.

Your first reaction to this should be that this weakens my argument, because I am using the same method of inference that I have objected to in the analysis about credit supply during the bubble.  The difference is in the scale of the evidence.  The relative shift in market values is greater, in scale, rate of change, and the number of cities that are affected.  In the handful of cities that did see low tier prices rise relative to high tier prices during the boom, I have presented a counter explanation for the cause.  It is possible, I suppose, that some counter explanation could explain why low tier home prices dropped in most cities after the summer of 2010.  As of today, I don't think there is any analysis published before the passage of Dodd-Frank that establishes a framework that led to an expectation that low tier properties would move roughly in line with high tier prices and then dramatically drop off after the summer of 2010 in cities like Atlanta, Seattle, and Chicago.

There are mysteries here, but if the argument that credit supply caused the housing boom was compelling, then this argument regarding Dodd-Frank seems at least as compelling.

Here are two graphs showing the home price behavior in the "other" cities that I described in the previous post.  (In these graphs, all prices have been indexed to 2000, and the measure is the monthly measure after 2000 of the average price of top quintile zip codes divided by the average price of the bottom quintile of zip codes.  The axis is inverted so that when low tier prices are declining relative to high tier prices, the lines move lower.)  These are cities that didn't generally take part in the housing "bubble".  Prices did rise in some, especially in Washington, Seattle, and Minneapolis, but as you can see in the graph, there wasn't much difference between low- and high-tier prices during the boom.  As I have described elsewhere, that was a phenomenon limited to a few cities where home prices were extremely high.  The only significant diversion between low- and high-tier prices in any of these cities during the boom was in Washington, Philadelphia, and Baltimore, where high-tier prices increased by more than low-tier prices.

In a few of these cities, low-tier prices had begun to drop before Dodd-Frank - Washinton, Detroit, Atlanta, and slightly in a few other cities.  But, the most common pattern here is for low-tier prices to remain within 10% of high-tier prices and then to diverge from high tier prices in 2010, so that after a few years relative high tier prices eventually were 20% to 80% higher than low-tier prices. (A measure equal to 1 means that high and low tier prices had changed by the same amount since 2000.  So, if the measure is 1.2, that means that high-tier prices had increased by 20% more than low-tier prices.)

I don't necessarily have a complete story here.  Maybe there isn't a way to directly connect the higher fixed costs of lending to specific changes in the market.  But, as with so many aspects of the issues I have uncovered, before we even address the gritty details, we should keep in mind how radically off-base the conventional narrative is for most cities.  Low-tier homes didn't explode to some unsustainable value, fed by loose credit, then inevitably collapse.  In most cities, prices across the city moved, more or less, in tandem.  Then, generally after the summer of 2010 - after the recession, after most mortgage delinquencies had happened, after employment began to recover, etc. - low tier prices in most cities experienced a relative valuation shock that was larger than anything which had happened before.

This has surprised me as much as anyone.  The scale of events during the boom and bust led me to miss the significance of Dodd-Frank, also.  Only recently have I noticed how late and how peculiar the home price deviations were in most of the cities that weren't Closed Access or Contagion cities.  And, I don't think this has much to do with the foreclosure crisis.  Many owners in these markets are long-time owners with large amounts of home equity.  So, rather than showing itself in more crisis-like dislocations, this has mostly affected two different markets: (1) older, working class homeowners who have lower net worth because their homes' values have been knocked down, and (2) young, first-time aspirational buyers who have delayed the purchase of their first home.

I think that is partly why this has gone unnoticed.  The effect is mostly on things that have not happened.  Households who haven't purchased a first home.  Households who didn't tap home equity to get through tough times.  Households who didn't move because they either didn't want to sell their undervalued home or they couldn't qualify for a mortgage on a new home.  These are less dramatic changes than foreclosures and failing banks, but they aren't necessarily less damaging to the broad march of economic healing.

PS.  Thanks to Zillow for all of this great price data.

PPS. A new paper from Bordo and Duca that finds a similar effect of Dodd-Frank on lending to small business. (HT: Tyler Cowen)

Saturday, April 14, 2018

Housing: Part 292 - Dodd-Frank was an unprecedented assault on working class homeowners.

I have looked at this from a few different angles already.

I have put together a new measure that helps to focus on the effects of credit collapse on home prices.  I have graphed the relative prices of the median homes in each zip code in the top 20 metro areas.  I split each MSA into 5 quintiles, by median home price.  Then, over time, I compare the relative change in those prices, indexed to the year 2000 (Quintile 5 divided by Quintile 1).

Here, I have taken the average measure for MSAs, which I have divided into three categories:

1) Closed Access cities (NYC, LA, Boston, San Francisco, San Diego).
2) Contagion cities (Miami, Phoenix, Riverside, Tampa).
3) Other cities in the top 20.

As I have discussed earlier, the peculiar rise in low-tier home prices which has been attributed to credit supply is (1) generally limited to the Closed Access cities and (2) happened because high tier prices systematically rise at a slower pace than low tier homes.  It is unlikely, then, that this effect was due to credit access to financially marginal borrowers.  Furthermore, there are an insignificant number of middle class home buyers in the Closed Access cities.  And, there was no relative rise nationally in borrowing among households with less income, education, etc.

We can see that in the graph, here.  I have inverted the y-axis, so that where low tier prices rose relative to high tier prices, the measure rises, and where low tier prices declined relative to high tier prices, the measure declines.  (This is all from the awesome data available at

Here, we can see how the rise in low tier prices was mostly in Closed Access cities during the boom.  Most of the effect in the Contagion cities was in Miami and Riverside, because prices there reached levels where high tier prices begin to level off.  In other cities, on average, low tier prices never rose at a faster pace than high tier prices.

The housing market was then faced with a succession of three credit shocks.

1) The CDO collapse.  The first shock hit private mortgage securitizations.  By scale, these loans were mainly facilitating home purchases by buyers with high incomes buying into Closed Access cities.  So, there was little effect in the other cities.  Even in the Contagion cities, relative prices of low tier homes only really began to decline in 2008.  The private securitization panic mostly hit the Closed Access cities.  (And, in hindsight, prices in these cities are justified by rising rents, and have continued to show strength in the long run, even in tight credit conditions.  Prices across the board have been stronger there.  And, notice that, while low tier prices in the Closed Access cities have retreated from their highs, they remain stronger than low tier prices in other cities.  Low tier home prices in every city have been hammered by credit contraction, but in total, credit contraction didn't hit the Closed Access cities any harder than it hit anywhere else.  That is because the relative rise of low tier prices in the Closed Access cities wasn't the result of credit supply.)

2) GSE Conservatorship.  Credit access was tightened to an extreme at the GSEs (Fannie Mae and Freddie Mac) after they were taken over.  Looking at FICO scores, the GSEs practically closed down lending to the bottom half of the existing market.  The book of business with FICO scores below 740 declined sharply, even in absolute terms.  The drop in Closed Access prices continued, and then leveled off.  The price drop in the low tier markets of Contagion cities accelerated.  And, the relative price drop in low tier markets in other cities started to moderately grow.

3) Dodd-Frank.  In the summer of 2010, with the passage of Dodd-Frank, a clear downshift happens in all of these markets.  In the Closed Access cities, the last bit of a downshift in low tier prices happens.  In the Contagion cities, where low tier prices were beginning to level off after the GSE shock, now reaccelerated downward.  And, now, low tier markets in other cities, which had never risen to high levels, and which had held up relatively well all the way until mid-2010, suddenly down-shifted.

It has taken me a while to fully appreciate the damage that Dodd-Frank did to the net worth of working class families in this country.  Maybe this graph is the best picture I have developed so far of the damage.  It would be difficult to overstate the gratuitous scale of the damage here.  This was the summer of 2010.  The entire country had just crawled through a generation defining financial crisis.  Unemployment was at multi-decade highs, and was beginning to finally decline.  Borrowers were losing their homes by the millions.  And most of the damage of Dodd-Frank was imposed on homes outside the Closed Access and Contagion markets that had made it through the crisis relatively unscathed!

This was after the crisis.  This was very late in the process.  Consider what we have done.  First, consider the Contagion cities.  This was a double-whammy to the Contagion cities, which had first been overwhelmed by a migration event as households flooded into their cities to escape the high costs of the housing-deprived Closed Access cities.  Then, when that migration event suddenly stopped in 2007 and 2008, their local economies and housing markets were devastated.  This was worsened first by the contraction in GSE lending, and then, after all of that, when homeowners across those cities were sitting on high double digit losses, another shock was leveled on them that pushed low tier prices another 15% lower compared to high tier prices.  So, by 2014, after this series of shocks, low tier home prices had been pushed down by more than 30% compared to high tier prices.  The misinterpretation of these events is so ubiquitous in the American conversation, that I can hear many readers, still, saying to themselves as they read this that this was simply a reversal of the excesses of the boom.  So, I will reiterate: This was a reversal of nothing.  These zip codes had never appreciated significantly more than the higher tier zip codes in their cities.  This was a wealth shock amounting to more than 30% of property values.

As devastating as this was to the Contagion cities, the story in the other cities is even worse.  In many other cities, prices in general had never risen to "bubble" prices.  And, in other cities, low tier home prices had managed to hang on relatively well, even through the first two credit shocks and the financial crisis.  These are markets with stable, low prices, which households with less savings and lower incomes can afford to purchase.  After the passage of Dodd-Frank, low tier housing markets dropped by 13%, relative to high tier markets.  From July 2010 to 2013.

The damage here has been drowned out by the scale of events of the other shocks.  But, imagine that it is 2007 again, and none of these shocks had happened.  Even the naysayers and housing bears would have considered a 13% drop, by itself, to be a cataclysmic event.  And of all of the zip codes in the country, these zip codes would have been at the bottom of the list of places where even the housing bears would have said that this sort of price drop might have happened.

Since public consensus has coalesced so strongly around the issue of banking risk and financial regulation, the conversation about Dodd-Frank has mostly been about its effects on banking stability.  But, in terms of its affects on working class housing markets, its effects have been disastrous.  We may just have well salted the fields or contaminated the drinking water.  Those policies would have been just as justified and just as useful.

It would be hard to conceive of a law whose timing and policy targets were more perverse.

Wednesday, April 11, 2018

March 2018 CPI

This month was a return to the recent norm.  On a month-to-month basis, rent inflation popped up and non-shelter inflation retreated.  But, March 2017 had a very negative reading, so on the year-to-year measure, inflation was almost certain to rise this month.

April 2017 had a pretty low reading too.  So, it still looks to me like we are basically in a holding pattern with shelter inflation above 3% and core non-shelter inflation hanging around 1%.

It still seems like this could, hypothetically, go either way, but the Fed has a hawkish bias, which I still expect to eventually turn things south.  I fear I'm becoming a perma-bear.  I swear I was bullish before.  I was shorting Eurodollars in 2013.

It is possible for things to go on like this for a while - healthy growth and de facto 1% inflation.  But, in an uncertain world, where there is bound to be stochastic movement, I think it's a good bet that the Fed will eventually get too far along and will be slow to pull back.  Slow credit growth, low inflation, and low investment levels suggest there isn't much of a buffer.

But, this has been going on for two years, so even if it happens, I can't really claim that I called it.  It is what it is, regardless.

Tuesday, April 10, 2018

My new policy brief at Mercatus

My new policy brief is up at the Mercatus Center.

Most of the content will look familiar to IW readers, but this is probably the best summary of the basic argument - that undersupply of housing caused the housing bubble.

Here is the take-away:
For a decade, the collapse has been treated as if it was inevitable, and the important question seemed to be, What caused the bubble that led to the collapse? This needs to be flipped around. Given the urban housing shortage, it was rising prices that were inevitable. So the important question is, Why did prices and housing starts collapse even though the supply shortage remains? And why were housing starts still at depression levels in 2011?
The surprising answer to those questions may be that a housing bubble didn’t lead to an inevitable recession. It may be that a moral panic developed about building and lending. The policies the public demanded as a result of that moral panic led to a recession that was largely self-inflicted and unnecessary. They also led to an unnecessary housing depression that continues to this day.

Sunday, April 8, 2018

Lending and the business cycle

Since I think tight mortgage lending has been the key variable holding back more healthy economic expansion, I have been watching some bank lending measures for signals of contraction.  I also think monetary policy is too tight because the Fed is using inflation measures that include a large amount of measured inflation that is due to the non-cash effect of owner-occupied rent inflation.  That high rent inflation is also a result of tight lending, which is keeping housing supply low.

There is an interesting relationship between commercial and industrial lending and the yield curve.

Lending increases during an expansion, with a bit of a lag, so it has parallel movement over time with the yield curve (here, 10 year minus 2 year, inverted).  Commercial and industrial loans tend to grow the most when the yield curve is relatively flat.  Then, when the yield curve inverts, this seems to be correlated with economic contraction and a newly steep yield curve.

But, this relationship has changed recently.  The yield curve remained relatively steep even while C&I lending moved back to expansionary rates of growth.  I suppose this would commonly be explained with the incorrect idea that the Fed has been holding short term rates too low, and that has been the source of the steep yield curve.

I think the more accurate explanation is that when interest rates are low, the zero lower bound causes the yield curve slope to increase, because long term rates begin to act like at the money call options.  There is a sort of premium embedded in future rates.  So, from 2008-2012, the relationship is similar to the typical relationship, but the yield curve is unusually high (lower on the inverted chart).

Until QE3, lending was starting to slow down, and long term rates were declining because economic sentiment was declining.  QE3 turned that around.  The yield curve steepened, and with a bit of a lag, C&I loan growth recovered.

Since then, it appears as if the relationship has reversed.  The yield curve has flattened while C&I loan growth has declined.  The first part of this period is from the end of QE3.  QE3 had boosted growth, so the end of QE3 was somewhat contractionary, but by the end of QE3, the neutral short term interest rate had probably recovered to something close to 0%, whereas it had previously been negative.

Then, the Fed began to raise short term rates.  This has two contrary effects on the yield curve.  The first effect is that it pushes the base rate up from the zero lower bound, which causes the inflated effect on long term rates to decline.  In other words, long term rates start acting more like in the money call options, so the embedded premium is lower.  This flattens the yield curve.

To the extent that the Fed raises rates back above the neutral rate, this also will flatten the yield curve by pulling down economic sentiment.  Both of these things are happening at the same time, which is doubly flattening the yield curve.  One effect is caused by expansionary factors (a rising neutral rate) and the other effect is caused by contractionary factors (a rising policy rate).  So, the question is, what effect is most at work.

And, the fact that C&I lending growth has been declining suggests that monetary tightening has been too strong.  There are many economic measures that seem to be at fairly benign levels, so this hasn't been confirmed by other data, so I have been in sort of wait-and-see mode.  Inflation data also hasn't confirmed either thesis, as both backward looking (non-shelter) inflation and forward looking inflation have been fairly flat, even if backward looking non-shelter inflation has been quite low.

I have had a bias for expecting the bear-reading of this situation to eventually play out, but recent lending has only complicated this, because suddenly, there has been a little bit of a spike in lending, and real estate lending has very slowly been growing for a little while already.  Is this a turnaround to new recovery, or is this a liquidity grab by corporations because nominal revenues are starting to weaken?  There isn't much evidence that things are bad enough to expect that to happen, so I have to wonder if this is part of a turnaround.

The mystery continues.

Tuesday, April 3, 2018

The stock and bond hedge in the Great Moderation

It looks like the cyclical relationship between interest rates and stock market trends was different before the Volker Fed than it has been after the Volker Fed.

The vertical marks  note times when short term interest rates began to decline.  Before 1980, this would usually happen after a stock market decline, and the stock market would recover when interest rates began to drop.  During that time, both bonds and stocks were gaining and losing value at the same time.

Since 1980, stocks have generally only started to lose value after interest rates began to decline.  During this period, bonds have gained value when stocks were losing value, so that they have served as hedging instruments.  I expect this to happen again.  There is a chance that in this cycle, stock prices won't give up much, like in the 1990-1992 period, in which case bonds will provide more of a speculative return if there is a general contraction, even though we are close to the zero bound.  A pure speculative position would probably require using something like Fed Funds Rate or Eurodollar futures, because short term notes don't have much price reaction to yields and long term bond yields don't change as much as short term yields.

It would be nice if high asset prices weren't an outcome that is explicitly avoided.  I am not saying high asset prices should be a goal, in and of themselves, by any means, but when the Fed pulled down short term interest rates in the mid-1980s and the mid-1990s, those moderating moves were probably an important part of the Great Moderation, where extended periods of 2%+ real economic growth per worker were only interrupted by minor recessions.

In both cases, the stock market reacted favorably, but both times (1987 and 2000) that was followed by a retreat, so stable economic growth has come to be associated with ill-advised risk-taking and "paper" wealth that leads to economic or market upheaval.

I would much rather live in the late 1990s than the 1970s.  Anyone would.  High inflation in the 1970s suggests that monetary policy actually was too loose then, and stocks hated it.  Workers did, too.  Unemployment was high.

In the 1990s, inflation was low, wages and employment were strong, and stocks like it.  The Greenspan put wasn't a form of monetary over-reach.  It was closer to monetary optimization.

We still have a relatively stable monetary regime, because inflation isn't going to get out of control, and the central bank will eventually provide monetary support during the contraction, but the fear of high asset prices now seems to have us in this de facto policy regime of keeping inflation low enough to target low wages and low asset prices.  I don't see the point of that, but it's where we are.  And, in the meantime, a flattening yield curve should indicate a coming broader contraction, which will signal declining short term interest rates.

I don't necessarily have a thorough explanation for the pre-Volker pattern.  In general it seems that inflation at the time was more pro-cyclical.  A primary feature of the Great Moderation period seems to be that inflation isn't as pro-cyclical.  It remains moderate during expansions.  That is a development for the better.  I wonder if we have become a little bit too afraid of success.  A couple more timely ticks down to avoid an inverted yield curve in 2000 and 2006, as happened in the mid-1990s, and maybe the Great Moderation could have been even Greater.

Maybe there is something about the way markets have evolved (more global corporate revenue bases?) that makes the stock market less of a forward indicator, and the fact that the stock market is bound to influence the monetary stance biases us to a slightly delayed monetary reaction.  Pre-Volker, the economy seemed to swing to sharp highs followed by brief crashes.  The 2007 recession was preceded by several quarters where economic growth slowly ground lower.  To a lesser extent, that was the case in 2000 and 1990.  Prior to that, recessionary shifts in growth tended to happen quickly.  It seems plausible that we have learned to do things pretty well.  We don't have numerous quick contractions anymore.  But there is something keeping us from loosening up when recessionary conditions slowly build.

Of course, the idea that moderation in the 2000s led to a housing bubble only serves to buttress this bias toward disinflationary instability.  I consider those slowing quarters in 2006 and 2007 to be early signs of cyclical miscalculations.  But, most people think the problem was that we didn't invoke that slow growth sooner.  The Moderation won't be Greater until that idea is reversed.

Monday, April 2, 2018

Housing: Part 291 - Learning the wrong lessons

Frequently, Dean Baker has interesting observations, and there are some interesting observations in this post at CEPR.  But, the post caught my attention because it contains a nice example of the wrong lessons of the financial crisis.

Baker is reacting against a columnist who uses stock prices as a measure of national economic well being.  Baker says, "The stock market is not a measure of economic well-being even in principle. It is ostensibly a measure of the value of future corporate profits, nothing more."

This is an unfortunate position, because clearly, economic well being is strongly related to equity valuations, both in cyclical and secular terms.  It's hard to know what the motivation is behind every single move in equity values, and increasingly, equity markets are global, so that equities aren't a pure measure of domestic economic trends.  But, every single unemployment shock is preceded by a decline in equity values.  The drop in equities always comes first.  The wide-spread dismissal of equity valuations as a measure of shifting economic fortunes is an exercise in cutting off one's nose to spite one's face.

It is unfortunate that Baker takes this position, because he has engaged in some good pushback against the idea that labor incomes have stagnated at the hands of some sort of naturally rising level of corporate profits.  Limits to entry are the primary cause of excessively high profits, and Baker has made that case.

Here, I think he is being thrown off by the standard story of the housing bubble.  He asks what would have happened if our wise leaders had explained to the fickle market that "market valuations did not make sense and that prices were likely to fall back to earth".  He writes:
In the first case, Clinton would have been showing that unless stockholders were willing to hold stock for returns that were far smaller than had been the case historically (and were roughly the same as the returns available on government bonds at the time) or future profits rose way faster than anyone economists were projecting, stock prices at the time could not be justified. 
Bush would have been showing how nationwide house prices had diverged from a century long pattern in which they had just kept pace with inflation. He could have also pointed out that this did not appear to be driven by the fundamentals of the housing market since rents continued to rise pretty much in step with inflation and we were seeing record vacancy rates. He also could have talked about the explosion of bad loans, which were widely talked about in the business press even before the collapse of the bubble. 
In both cases, the Lowensteins of the world could have blamed the president for tanking their stock portfolios and they would be right. Their truth telling would have destroyed trillions of dollars in paper wealth and it would have been a very good thing.
It is true that a 20 year investment in the S&P 500 in March 1998 would have barely returned more than an investment in 20 year treasuries.  But, this has come during 20 years with low real and nominal GDP growth.  Hindsight is 20/20, but long term forward returns were not pre-determined.  Even if they were optimistic at the time, equity holders have indeed been held back by real shocks to economic growth since then.  Unanticipated real shocks are almost always more important for equity holders than valuations.  What does it mean that this was only "paper" wealth?  Equity holders at the time expected at least 8% or 9% nominal returns, which is about what they generally expect, and it is about what they would have received if GDP growth over the following 20 years had been normal.

Where does wealth stop being real, and start being "paper"?  When they expect 7% returns? 10%?  Where is the line in the sand where wealth isn't real anymore?  I don't think the evidence suggests that this expectation changes much over time, but what if it did?  Do we really want to base our public economic policies on the idea that any equity prices based on returns under 8% are fake and prices must be tamped down until capital gets a higher return?

There are two ideas that support these ideas about high asset prices coming at labor's expense. (1) That corporate values are based on future operating incomes which come at the expense of labor share of income. and (2) that corporate values are just flying around willy-nilly, unrelated to anything, and when they are up, capital owners get to act wealthier than they are until the crash comes, and then laborers get brought down with them.

Both of these ideas are wrong, and these wrong ideas are both reinforced by factual and conceptual inaccuracies about the housing bubble.

(1) is reinforced by the complaint that labor share of national income has been falling.  But, labor share is falling because rents for housing are rising, not because operating incomes of firms are rising.

(2) is reinforced by the idea that we had a stock market bubble followed by a housing market bubble, and that neither market was justified by the fundamentals.  Readers of this blog know that housing prices were largely justified by the fundamentals, and that a key error that is usually made is to think that prices had nothing to do with rents.  We know that prices have been highly related to rents.  The bubble happened in California, New York, and Boston because rents in those places were rising so sharply.  And, the bubble happened in Arizona, Nevada, and Florida because so many households were moving out of California, New York, and Boston.

And, Baker is correct that the press had many stories of bad loans before the collapse of the bubble, but empirically, defaults were triggered by falling prices, which first hit households with high incomes and only much later hit households that were default risks for economic reasons.

This notion that asset prices were unmoored from fundamentals is largely a product of fallacies.  So, it is true that equity holders would have been right to blame the president for tanking their portfolios.  It is Baker that is wrong that this would be a "very good thing."  Baker is hardly alone in this position.  And, really, do we need to know any more than that to understand why the American economy has been running on three cyclinders for the past decade?

Home prices are inflated because of monopolistic legal barriers to new homes, and we resolve to make them unaffordable by removing the means for purchasing them until those prices relent.  It turns out that important factors for making homes affordable include being employed, receiving growing wages, and having a healthy banking system.

One last comment I would make is that there are two different things going on here.  The stock market bubble was based on optimism about the economy in general.  But, the housing bubble was based on monopoly rents going to holders of capital.  Yet, Baker says that in both cases, valuations were outside historical norms and didn't make sense.

Housing prices did make sense because of legislated monopoly of real estate owners in the "Closed Access" coastal metropolises.  Baker should recognize that as clearly as anyone, but there is no voice within his earshot correcting the errors that have built up around the explanations of the bubble.

So, just like the country's opinion leaders went whistling past the graveyard in 2007 when house prices started to collapse, we will do it again this time when nominal incomes start to stagnate, until the right lessons are learned.