Money Supply Blues

As I hear more and more about this economic crisis, the pundits and politicians' voice begin to merge and it becomes a sort of white noise. There isn't much sense to be made out of most the reports, so as a statistician I prefer to look at data and see what the real story is. Data sometimes lies, but to be frank it lies a lot less than politicians and businessmen scrambling to keep their jobs. I went to the Bureau of Labor Statistics (BLS) website for some graphic interpretations of various economic data. As I had said back in March, the United States is in a recession, perhaps the worst in a very long time. But what does the data say about this? Inflation is currently at 3.7%, not much different from last year. The unemployment rate (6.7%) increases every month, but we're still nowhere near where we were in 1982 when the rate was around 10 percent. What really worries me is not the labor indicators, it's the monetary indicators. Check out the latest data and you will see what worries me.

In a little over a month the total money supply for Treasury and the Federal Reserve have sky-rocketed. This is the medicine that is supposed to soothe the credit markets. But at what cost? As Milton Friedman pointed out, inflation is always a monetary problem, how prescient. Some may say, so what? These are hard times that call for drastic measures. The cost of these drastic measures has been the potential implosion of the American government's credit-worthiness. To increase this money supply, debt must be sold, and interest paid to debt-holders. As this debt grows, it is nearly certain that the dollar will begin to lose its value. We saw this last year when the dollar plummeted against the Euro. This would change after Europe entered its own downturn, but the lesson remains. The danger of applying Keynesian economic theory is that in trying to breathe life into an economy one may end up destroying it instead.

One must ask during times such as these, how much government intervention is necessary to stave off disaster? Many people, including the insulated folks in DC, ponder this question as if it is abstract, and there are no real consequences to such tinkering. Much of this downturn can be attributed to overzealous tinkering in the housing market. If the government cannot take responsibility for their complicity in this matter, what makes you believe they have the wherewithal to fix it? We are witnessing the government solution, which is to print money. We are walking down a dangerous road, not unlike the 1930's. Government interference in economic markets exacerbated what could have been a severe recession and helped it become a depression. We have historical precedent, I can only hope that decision-makers will pay attention, but you'll pardon me if I doubt it.
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How the government can help

As many people may know, the Fed has changed its long-standing policy of being the lender of last resort only to regulated-commercial banks. This turn became apparent with the backed rescue of Bear Stearns two weeks ago. They have provided the credit market with liquidity and has done its job of making sure the credit markets don't completely collapse, along with any consumer confidence in the markets. But what of the housing market? Is there anything the government can do to facilitate the recovery of the housing market? We read of Hillary Clinton's call for the government to buy up sub-prime mortgages and Barack Obama's call for additional stimulus money (about $30 billion last I heard). Most approaches from the fiscal side embraces the idea of the state solving the problem. I propose that they not solve the problem per se, but do their part to allow the market to solve the problem itself. What I speak of is the real estate short sale and what the government can do to facilitate them.

A short sale is when a homeowner sells his or her house for less than what they owe on the house. This leaves a remainder for the houseowner to pay. In a short sale, the bank can agree to forgive the remaining debt on the mortgage basically in exchange for the home being sold. The down side of this deal is that the difference between the selling price and the mortgage debt is taxable income. In some markets, houses are losing hundreds of thousands of dollars in value. That is a lot of money to be added on someone's tax return as income. So much so in fact, that homeowners may still choose bankruptcy or foreclosure because they cannot afford this loss. This is where the government can help.

A well-regulated fiscal policy by the US government can forgive that loss through legislated tax policy. The government through its tax policy can facilitate short sales all over the country. If that loss is not counted as income, then this may lubricate the market better than any liquidity policy by the Federal Reserve.

This will revive the real estate market in several ways. First, it will allow buyers to enter the market again through short sales. Banks, needing better collateral to loan again, will have a lower price to loan a potential buyer. A lower price means a higher likelihood of having the 10-20% down on a new home. The mortgage market can move away from the fast-cash, no collateral, interest-only ways toward a more stable credit market with buyers with better credit. Second, this prevents the banks from taking on countless assets on their balance sheet through foreclosure, which will be sold at a loss anyway. Why not take that loss upfront, with someone not only still occupying the house, but still paying a mortgage? It may be less, but it is a lot more than if the bank was forced to bear the costs of foreclosure. Lastly, it will guide the housing market toward a more natural equilibrium. No one can argue that the housing market was inflated by the time of this downturn. A downward correction is needed, encouraging short sales will facilitate this correction.

If the government regulates these short sales to prevent misuse and fraud (and this is a big IF), then tax-forgiveness can be the lubrication the real estate market needs to move toward stability. A poorly regulated financial market, facilitated by the Fed's cheap money policy from 2001 to 2007 caused a white hot rise in real estate prices. They are coming down, and some argue they have further to fall. Now, this can be an absymal crash or it can be guided landing. The government has the fiscal authority to change tax law. Forgiving this mortgage debt is how the state can help. It is a minimal intervention, but it can have maximum effectiveness if it is done soon. The state will intervene at some point, let's just hope it is with the feather touch and not the iron fist. We may all lose in the end if that fist comes crashing down.
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1929 all over again?

As anyone reading this blog may realize, my eyes have turned on to this country's current economic crisis. I've been seeing a few news articles that suggest that this recent turmoil in the financial markets is dangerously similar to the crash that occurred in October 1929. When historians remember the Great Depression, they point at one moment as the turning point: Black Friday. Normally, the way it is read is that of some kind of cause; what most may not realize is that Black Friday was an effect. We would be wise to remember the lessons of 1929-1930. If we do, then we will see that today's problems are not that of the Great Depression, at least not yet.

A myth, propagated by the likes of J.K. Galbraith, blame the crash of 1929 on impetous investment and an immature margin system. Too many people bought too much stock with credit, and a chain reaction of margin calls sent the stock market into a downward spiral that caused the Great Depression. Though the stock market did in fact crash, this was a response to government legislation, not irrational investing. The legislation I refer to is the Smoot-Hawley Tariff of 1930 which sliced this country's imports in half, nearly overnight. An Act that spurred retaliation tariffs from other countries and ground international trade to a virtual halt. The crash of 1929 was in response to the likelihood that Herbert Hoover was going to sign the Tariff into law. Investors were not irrational as some would believe. They knew what was coming, and a massive sell-off was the result. This sell-off culminated on Black Friday. This sell-off was the result of a government's attempt to heal an economy by restricting international trade. It was the greatest backfire in this country's history.

There are similarities between today's markets and those of the late 1920's. The tariff was passed in response to a recession in 1929. A recession that occurred as countries were still healing from the First World War. Our government tried to "fix" our economy and ended up destroying it instead. What will we do now that our economy has faltered? Xenophobic rage is boiling up again, with hatred for China, India and other countries that have "stolen" our prosperity. Will we again try to block international trade in response to a recession? It could happen. Listen to today's rhetoric, especially from the Democrats. Free trade is the cure to this mess not the disease. The lessons from history are laid bare for all to see, do not ignore it; for a wise man once said those who ignore history are bound to repeat it.
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Why buy American?

If anyone is unaware, let me be the first to let you know that this economy is, in fact, in a recession. Now that is not official, but last month private industry shed over 100,000 jobs. There should be little doubt at this point that our economy is shrinking. But, what does this mean? Besides the obvious fact that many Americans are now out of work, or looking for work, there is the predictable backlash against some scapegoat. Our economic woes aren't our fault, they must be someone else's. I recently received this email that perfectly illustrates what I'm talking about:

As you may have heard the Bush Administration said each and every one of us would now get a nice rebate. If we spend that money at Wal-Mart, all the money will go to China. If we spend it on gasoline it will all go to the Arabs, if we purchase a computer it will all go to India, if we purchase fruit and vegetables it will all go to Mexico, Honduras, and Guatemala, if we purchase a good car it will all go to Japan, if we purchase useless crap it will all go to Taiwan and none of it will help the American economy.

We need to keep that money here in America, so the only way to keep that money here at home is to buy beer, since those are the only businesses still in the US.

What these statements show is a sign of the times, and a shallow knowledge of economics and trade. It is short-sighted to assume that since we buy something from somewhere, that money is gone and we are at some net loss. We are living in a global economy, and America is losing its status as the powerhouse. I imagine that upsets a lot of people. I guess many Americans believe that we should be manufacturing goods, and if we are not, then we are somehow worse off. There is a reason we get all these products from the abovenamed places. They are less expensive! We are buying these products at a lower price than what can be produced here, and we end up with more money in our pocket to spend on something else. We have a net gain! We are better off, why can't anyone see this?

Buying our products at lower prices not only helps consumers, but it also spawns new industries. There is a reason why sales is one of the hottest jobs today. Someone has to package and distribute all these foreign products in America. Who do you think does all this? Americans! Jobs are also created by international trade. For the last ten or so years, we have been trading with these international partners. I didn't hear people complaining then. Only now, after our own housing market and financial industries have collapsed do we turn to the foreign monster.

It is time that we move on from this pointless xenophobia. International trade is a boon to all who participate. Shift can sometimes be painful, as many Americans are noticing, but new jobs and new industries come from this shift. New opportunities will come. Trying to persuade an otherwise ignorant consumer to buy American simply for the fact that it is American is a great way to ensure that this recession continues. You want them to spend more money than they did yesterday for a product because of where it is made? If a product is good, then buy it, it doesn't matter where it comes from. A prosperous global economy makes the world better off and in the long run it will make America better off. Look past the foreign-bashing, and you will see that.
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Why Keynesian Economics won't end this

I've written on the ideas of why Keynesian economics does not work in the past. Simply put, an unproductive government cannot be trusted to make better decisions with people's money than they themselves. The saddest thing is that voices like this are being drowned in a sea of populist economics.

Since the time of FDR and the disastrous policies of the New Deal, governments have been trying to ease economic woe with policies fraught with unintended consequences. We've already seen the first strike from fiscal policy. The Congress and President made record time in passing legislation giving everyone in the country a tax rebate check. This reeks of political posturing in an election year. That check will do as much for the economy as attempting to put out a forest fire with a squirt-gun. But, this is the playbook for economic downturns. Encourage consumption through either government programs (WIC, Welfare, Social Security, etc.) or through direct payment (rebate checks). These programs will do nothing to consumption in the long-run, even in the short-run its effects are questionable.

It appears to me that this economy is undergoing a general deflation from an artificial inflation. Two examples lend credence to this idea. First, the housing market. Thanks to the Fed's cheap money policy and perverse economic incentives, housing prices skyrocketed far past anything that can be attributed to a rise in value. People with awful credit were allowed to take out hundreds of thousands of dollars in loans and credit. Even some with reasonable credit dove in over their heads. Now the market is shrinking, there will be a lot of casualties.

But what about the weakening dollar? Through this government's excessive and destructive spending on credit, the dollar became very strong through foreign investment. The dollar kept its status as long as our economy was strong. Now that the economy has turned, those investments aren't so great. That investment is starting to wane, and this is showing up in the flight to commodities (ahem, gold and oil). If the government sticks by its Keynesian guns and tries to spend its way out this, then you can expect even bigger problems than we have today.

An unbridled government spending spree will weaken the dollar even more. This means higher oil prices (oil price is tied to the dollar), as well as higher overall prices, since cheapness in exports will have been washed away in a high exchange rate. Remember, there are consequences to unwise spending. We found that out in the 1930s with the depression, in the 1970s with inflation and gas lines, and today with both a crumbling housing market and a freefalling dollar. Unless the government reins in spending (through perhaps a Balanced Budget Amendment), we can expect to see a lot more widespread suffering, as the State tries to "fix" this problem. Unlikely, but we can always hope though, can't we?
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Human Behavior in a Free Market

I just read an article that says that 45 percent of economists believe that we are headed for a recession, the other 55 don't believe that we will have a recession, more of a "relatively muted" downturn. I suppose most people would read this and wipe that sweat from their brow and say phew! that was close. I remain my ever-cynical self though. The worst part about this report is to know whether these future predictions will come true. They could be absolutely correct, but they could be absolutely wrong.

The reason I say this is in the name of praxeology (study of human behavior). To try and predict what millions of people are going to do tomorrow is impossible, even with a copious amount of data. What that data indicates is the past performance, which is no indicator of the future. Data analysis, especially in economics, is sketchy at best. The best that economic indicators can do is say, "if all things remain the same, this curve can predict the future." What economic analysis cannot predict, no matter how hard they try, is the anomaly of shocks. These can be as small as a new trend pushing the market in an unexpected direction or as large as planes flying into buildings, precipitating what was a simmering recession in 2001.

Who could have predicted in July, that in August we would see the beginnings of the latest credit crunch? What about a Hurricane that would destroy much of the city of New Orleans? Who could have predicted in August 2001 that one month later this country would suffer the worst terrorist attack in its history? It is shocks like these that make economic prediction at best an expensive preoccupation and at worst a horribile misguidance.

The beauty of the free market is the sheer inability for anyone to predict collective action in any reliable way. Just look at the stock market. With all our technology and brain-power, we still can't figure out when those shocks are going to occur, and which way a company's value is going to go from day to day, much less from year to year. Don't be taken so quickly by economists' prediction, the free market is not so easily lassoed.
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On a Housing Crisis

I've read quite a bit about the recent credit crunch, and it usually leads me to contemplate the state of the US economy (I hear much of the same is happening in Western Europe, but I can only really account for what I see and know). I've studied the most on what is happening (on a macro scale) in the US housing market. Every time I see that the Federal Reserve lowers its discount rate to stave off some recession, I just have to shake my head. So much of what is happening now is a result of the unbridled growth in the Housing Market thanks to very cheap money.

What tinkering Central Banks seem to not realize is that the very things we are fighting to stop a recession were the result of low-cost money through low-interest and eventually unwise investing. Many forget that interest rates are the product of a free market, and that tinkering with that interest rate can have serious consequences. An interest rate is the bargaining equilibrium between savers and spenders. That rate represents the crossroads between future preferences versus present preferences. The savers (who have future preferences and must be paid to lend that money--interest rate.) and the spenders who pay that interest rate so that they may have their money now. When this interest rate is manipulated, mainly through Central Banks, this can throw a market off-balance to favor either the buyer or the seller.

We can see just why housing prices rose the way they did from the availabilty of many loans with little collateral to ensure a good investment loan. With different sorts of lending packages and investment vehicles, the last few years saw a very quick rise in house prices due to availability of money, cheap money that is. The interest-only loan, which only demand payments on the interest, not the principal, gambles that the price of the house will increase to profit from the purchase. For years, those housing prices increased with little abatement. Now that the credit machine of the United States (and a lot of Europe) has seized up, these homeowners can no longer count on a quick turnover of their investment. The problem with interest-only loans is that they mature and after a said amount of time demands payment of both interest and principal, something many homeowners cannot afford. This crowding up of sellers means now prices must fall.

As the Economist so adroitely pointed out, housing prices tend to be very sticky. Homeowners are not very quick to drop the price of their homes, many times because of stubbornness, but unfortunately also because they simply cannot afford to take the loss, that is if there is a buyer to sell to. We were able to sell our condo before this housing market went so sour. My wife and I had purchased a home, with no money down and with a nice mortgage payment from an interest-only loan. After a few months, we found we could no longer afford to live there presently, and we would certainly have foreclosed if our payment had included principal. We were lucky enough to sell our place and actually still made a nice profit. Many who are in the same circumstances now are not as lucky as my wife and me.

The Fed can lower interest rates, and there may be somewhat of a recovery, but that does not mask what has really happened: inflation in the housing market. When housing prices stop rising, there is less of an incentive to get an interest-only loan, so we should see less of those. As houses sit on the open market, a downward correction must occur to bring the housing market back to an equilibrium. Treasury can delay many loan maturities, but those loans have to mature sometime. What are we going to do then? These prices cannot stay this high and continuing to artificially inflate those prices, it just means that we have that much further to fall. A correction is needed, the longer it is delayed, the worse it will get. Let's wait and watch.
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